Knowledge that Transforms

Abstract Relying on their history of legal infractions to measure individuals' risk tolerance, we examine the association between engagement partners' risk appetites and audit quality in the United States. Criminology and economics research links infraction activity with enduring personality traits that capture an individual's risk tolerance. Our evidence supports the prediction that partners known to engage in risky off‐the‐job behaviors conduct lower quality audits. Specifically, we find that clients of partners with prior legal infractions exhibit a higher likelihood of material misstatements revealed through subsequent restatements, greater propensity to misstate based on the F ‐score, more instances of “missed” material weaknesses, and less timely loss recognition, while also paying lower audit fees. In cross‐sectional results consistent with expectations, we generally find that the impact of partners' risk tolerance on audit quality is more heavily concentrated in clients of non–Big 4 firms and offices without industry expertise. Collectively, our analysis contributes to emerging research on the role that individual partner characteristics play in shaping audit outcomes.

ABSTRACT The current biodiversity loss is dramatic. Over the past 50 years, more than 68% of the mammals, birds, amphibians, reptiles, and fish on Earth have disappeared, putting the planet's survival and its inhabitants—including human beings—at risk. Financialization, or the transformation of nature into financial assets, is increasingly proposed as a solution to the biodiversity crisis. Proponents of financialization believe that assigning a monetary value to nature will incentivize human beings to protect habitats and their species. This article offers a four‐mechanism model of nature's financialization, explaining why it is virtually impossible to financialize nature. We collected data through a unique two‐stage data collection process, including a single case study and additional interviews with conservationists and conservation finance specialists. We analyzed the development of a calculative device, the “Index,” designed to assess the impact of conservation efforts on the survival of endangered species. Conservationists hoped to use the Index to calculate the financial return of a conservation impact bond, a financial instrument designed to finance conservation projects. However, they did not achieve their goal. We discuss the implications for the financialization and conservation literature and the role of accounting therein. We notably question previous accounts of financialization, including the need for financial numbers or financial actors. We ultimately show that a financialization project can transform practices toward financialization, even if the financialization process is not complete.

Abstract I examine how changes in analysts' workloads affect their information production. Examining determinants of analysts' information production is important because analyst research affects stock prices and capital allocation decisions. Using periods when analysts work on IPOs to proxy for shocks to their workloads, I predict and find that the accuracy, quantity, and timeliness of analysts' forecasts for non‐IPO firms decline when they are working on IPOs, and they herd closer to the consensus. The reductions in research quality are larger for less experienced analysts, larger IPOs, and less important portfolio firms. Last, I predict and find that information asymmetry increases for non‐IPO firms covered by analysts who are working on IPOs, consistent with analysts' reduction in research quality during IPO assignments negatively affecting the information environment of non‐IPO firms. In sum, I provide the first evidence that analysts' work on IPO deals imposes negative externalities on both the quality of research they produce for the non‐IPO firms they cover and the information environments of these firms, highlighting at least one reason why analyst workload is important to firms and investors.

ABSTRACT We design three experiments to examine how group incentives moderate the motivational effects of cash versus tangible rewards. Our first experiment shows that, relative to individual incentives, group incentives can magnify any negative effect of the uncertain attractiveness of a less‐fungible tangible reward (versus cash), as group members must evaluate not only how attractive they find the reward themselves but also how attractive other group members are likely to find it. However, as we show in our second experiment, under group incentives, structuring a tangible reward as a shared experience among group members who like each other can mitigate any demotivating effect of an individually consumed tangible reward vis‐à‐vis a cash reward. A third experiment provides process support for our theory, showing that both the attractiveness of the reward and the degree of certainty that others will also find it attractive jointly and fully mediate our findings. As a whole, our study furthers an understanding of the multifaceted dimensions of tangible rewards, identifying incremental effects that can arise when tangible rewards are combined with group incentives.

ABSTRACT Researchers typically infer real earnings management when a firm's operating and investing activities differ from industry norms. A significant problem with classifying deviations from industry averages as myopic earnings management is that companies can change their operating and investing decisions for strategic business reasons rather than to mislead stakeholders. Using principal components analysis, we systematically evaluate existing measures and develop a comprehensive real activities measure to better capture earnings manipulation. Our measure reflects (i) deviations from industry averages across multiple activities and (ii) other signals of manipulation. This approach is promising because, although there are many sources of abnormal activities, manipulation is more likely the cause when managers engage in multiple income‐increasing abnormal activities that coincide with other signals that indicate an elevated risk of manipulation. This simple approach results in a metric that associates negatively with future operating performance and earnings persistence, yields high‐power tests, and captures manipulation reasonably well across most life‐cycle stages. Importantly, this approach performs better than the standard real earnings management metrics across all dimensions. Specifically, it generates the expected reduction in future earnings and reduced earnings persistence in 82% of the tests compared to 36% and 46% in common alternatives. Also, because this innovation does not require a long time‐series or rely on future period realizations for classification, it can be useful in more research settings than other recent innovations in the literature.

ABSTRACT The rise of stakeholder governance has triggered a wave of legal initiatives to strengthen the employee voice in firms. However, how managers trade off the competing objectives between shareholders and employees when making financial reporting decisions is not well understood. Exploiting staggered employment protection laws (EPLs) across 26 countries, we find that managers facing strong EPLs report more opaque earnings. Exploring the mechanism, we show that EPLs induce manager‐employee alliance: EPLs enhance employees' power to influence managers' private benefits and create an incentive for managers to treat employees more favorably, leading to an increase in manager‐employee reciprocal benefits. Further analysis shows that the alliance drives the increase in opacity following EPLs. Such alliance‐induced opacity impedes the ability of institutional shareholders to make timely adjustments to portfolio holdings in response to EPLs. Last, we identify several governance mechanisms that help break the manager‐employee nexus and restore reporting transparency. Overall, our study documents manager‐employee alliance as a potential cost of rigid labor laws and an important source of managerial reporting bias.

Abstract Corporate spinoffs are important events that are accompanied by valuation and credit‐risk implications for the parent firm. Among other benefits, spinoffs can improve corporate focus and enhance valuation transparency. In the debt‐contracting context, however, spinoffs can also be associated with negative outcomes for the divesting firms. We examine whether banks, due to their timely access to material private information, are able to ascertain the likelihood and the implications of impending spinoffs for the parent firm before a formal public announcement of the spinoff. Our empirical analyses indicate that, in the 365‐day pre‐spinoff announcement period, banks charge incrementally higher (lower) spreads to borrowers with increased (decreased) post‐spinoff riskiness relative to nondivesting firms. This suggests that, while lenders recognize the value‐ and transparency‐enhancing effects of spinoffs, they are also able to foresee potentially negative implications of these divestitures. Cross‐sectional analyses indicate that banks charge incrementally lower loan spreads if spinoffs result in high‐risk borrowers having either higher reporting quality or lower reporting or operational complexity. These results suggest that the post‐spinoff increase in riskiness is compensated by the divestiture benefits typically associated with spinoffs. Similarly, high‐risk borrowers incur larger spreads if they do not undergo “focus‐increasing” spinoffs. Overall, our findings suggest that banks are able to ex ante determine the implications of important corporate events such as spinoffs.

ABSTRACT This study examines the interplay between tax and internal reporting incentives among affiliates of multinational corporations (MNCs). MNCs face limited information flows that may prevent affiliates' performance metrics to be responsive immediately to changes in the firm's tax planning. Using granular data of affiliates belonging to MNCs from 21 European countries, our study provides new empirical evidence of affiliate internal reporting responses induced by changing tax plans. When high‐tax‐rate countries tighten income shifting rules, we first document that income shifting is reduced and low‐tax‐rate affiliates have less income. Second, we predict and document that managers of these low‐tax‐rate affiliates offset this decrease in profits by managing upwards a key performance metric: affiliate earnings. Our results are consistent with firms not quickly adjusting the affiliate managers' incentives in the face of changing tax planning strategies, and affiliates managing reported earnings to offset the effect of changes in the tax planning of the firm. Cross‐sectional analyses provide further evidence consistent with the theory underlying the main tests. The results support the policy of tightening income shifting rules when the objective is to reduce income shifting, and firms' central management would benefit from considering the implications of changing tax plans on the assessment of local managers.

Abstract Global tax enforcement policies have received increased attention since the financial crisis, with much stated focus on curbing perceived harmful tax practices of multinational corporations. Yet there is a dearth of evidence on possible differential effects of home‐country tax enforcement on multinationals. We take a step toward filling this void in the tax policy discussion by examining whether there is a differential relation between changes in home‐country enforcement and the tax avoidance of domestic versus multinational corporations. Using OECD data on 50 countries from 2005 to 2019, we find increases in home‐country enforcement are associated with lower levels of tax avoidance for domestic firms than for multinational corporations. Using a subset of firms from the Bureau van Dijk database, we find that multinationals avoid more tax in foreign countries when home‐country enforcement increases. Results are stronger for multinationals with a higher proportion of subsidiaries in low‐tax countries and when enforcement spending is low. These findings have implications for policy‐makers and highlight the importance of coordinated enforcement efforts across jurisdictions—such as the recently proposed global minimum tax—to successfully curb multinationals' worldwide tax avoidance.

ABSTRACT The recent revisions of conceptual frameworks (CFs) by the IASB and the FASB included changes to the status of prudence/conservatism, accompanied by a broader debate about the meaning and role of asymmetry in financial accounting theory (FinAT). This paper adopts a historical perspective to identify possible sources of the current controversies by examining how the discourse on asymmetry has developed over time. For this purpose, we trace the conceptualization of asymmetry in FinAT building from the 19th century until 2018, covering contributions to the US FinAT literature and the conceptual reasoning of standard setters (and their constituents) in the United States and at the international level. We identify four distinct constructs of asymmetry (ultra‐, specified, discretionary, and neutral asymmetry) developed in FinAT under the headings of “conservatism” and/or “prudence.” Our analysis reveals that the respective historical circumstances strongly influenced which notion and role of asymmetry were commonly accepted in FinAT, while the arguments underlying the debates were going in circles and were characterized by an increasing level of abstraction over time. We conclude that the controversy about asymmetry is partially due to conceptual ambiguity but also due to different assumptions about the objective of financial reporting and attributes of the preparer, which are indicative of two conflicting paradigms shaping the FinAT discourse on asymmetry. Our findings point to gaps and limitations in the deductive CFs currently employed by the IASB and FASB. Our study highlights future research potential regarding the construction of the preparer in standard setting and analyses of the ways in which deductive CFs (fail to) translate into consistent standards.