Section 404 of the Sarbanes-Oxley Act and Auditing Standard No. 2 introduced integrated audits of internal control over financial reporting and the financial statements. Since the internal control and audit reports are joint products of the audit process, we examine whether the issuance of an internal control material weakness opinion (MWO) influences, other things equal, the issuance of a going concern audit opinion (GCO). Using a sample of financially stressed companies, we find that the issuance of a MWO increases the likelihood of a GCO, suggesting that auditors do respond to the uncertainty surrounding a MWO by issuing a GCO. Further analyses reveal that the positive association between MWO and GCO obtains for company-level material weaknesses, which are known to be difficult to “audit-around”, and for more litigious industries. We also compare these results with those for a Section 302 sample with manager-reported (but not audited) material weaknesses, and find that the material weakness reported under Section 302 does not impact the GCO. Hence, the auditors respond to the uncertainty surrounding material weaknesses only when they issue MWOs, and not due to the existence of material weaknesses per se – that is, the issuance of a MWO seems to induce further conservatism in the auditor’s GCO decision. We conclude that researchers and policymakers should consider the overall effect of Section 404 on the financial statement audit.

ABSTRACT: This study examines the relation between internal controls and conditional conservatism (“conservatism”), also referred to as timely loss recognition. Using a sample of firms that disclose material weaknesses (MWs) in internal controls under the Sarbanes-Oxley Act (SOX), we find a positive relation between internal control quality and conservatism. Specifically, firms with MWs exhibit lower conservatism than firms without such weaknesses. Further, firms that disclose MWs and subsequently remediate these weaknesses exhibit greater conservatism than firms that continue to have MWs. Overall, these results are consistent with strong internal controls acting as a mechanism that facilitates conservatism. Our study contributes to the literature on the reporting effects of strong versus weak internal controls.

Abstract How do corporate bond mutual funds manage liquidity to meet investor redemptions? We show that during tranquil market conditions, these funds tend to reduce liquid asset holdings to meet redemptions, temporarily increasing relative exposures to illiquid asset classes. When aggregate uncertainty rises, however, they tend to scale down their liquid and illiquid assets proportionally to preserve portfolio liquidity. This fund-level dynamic management of liquidity appears to affect the broad financial market: Redemptions from the corporate bond fund sector lead to more corporate bond selling during high-uncertainty periods, which generates price pressures and predicts strong return reversals.

This paper examines the impact of stock liquidity on firm bankruptcy risk. Using the Securities and Exchange Commission decimalization regulation as a shock to stock liquidity, we establish that enhanced liquidity decreases default risk. Stocks with the highest default risk experience the largest improvements. We find two mechanisms through which stock liquidity reduces firm default risk: improving stock price informational efficiency and facilitating corporate governance by blockholders. Of the two mechanisms, the informational efficiency channel has higher explanatory power than the corporate governance channel.

We examine stock exchange trading rules for market manipulation, insider trading, and broker–agency conflict, across countries and over time, in 42 stock exchanges around the world. Some stock exchanges have extremely detailed rules that explicitly prohibit specific manipulative practices, but others use less precise and broadly framed rules. We create new indices for market manipulation, insider trading, and broker–agency conflict based on the specific provisions in the trading rules of each stock exchange. We show that differences in exchange trading rules, over time and across markets, significantly affect liquidity.

Markets can give false impressions of liquidity and stability if failed attempts to trade are ignored. For collateralized loan obligations, we quantify this bias by estimating the total cost of immediacy (TCI) which incorporates failure rates and failure costs. TCI is substantially higher than the observed cost, 0.3–3.8% versus 0.04–0.12% across credit-quality tranches because trade failures are frequent, failure costs are large, and failure costs and rates are correlated. TCI is almost double the realized gains from trade for low-rated tranches. Overall, auction-based over-the-counter markets become illiquid and fragile, especially during stressful periods for low-rated assets.

We examine the extent to which institutional investors herd in the U.S. corporate bond market and the price impact of their herding behavior. We find that the level of institutional herding in corporate bonds is substantially higher than what is documented for equities, and that sell herding is much stronger and more persistent than buy herding. The price impact of herding is also highly asymmetric. While buy herding facilitates price discovery, sell herding causes transitory yet large price distortions. Such price destabilizing effect of sell herding is particularly pronounced for speculative-grade, small, and illiquid bonds, and during the financial crisis.

ABSTRACT Fire sales induced by investor redemptions have powerful spillover effects among funds that hold the same assets, hurting peer funds' performance and flows, and leading to further asset sales with negative bond price impact. A one‐standard‐deviation increase in our fire‐sale spillover measure leads to a 45 (90) bp decrease in peer fund returns (flows) and a two percentage point increase in the likelihood of a large bond price drop. The results hold in a regression‐discontinuity design addressing identification concerns. Timing, heterogeneity, instrumental‐variable, and placebo tests further support the price‐impact mechanism. Model‐based counterfactual and stress‐test analyses quantify the financial stability implications.

ABSTRACT We examine the network of trading relationships between insurers and dealers in the over‐the‐counter (OTC) corporate bond market. Regulatory data show that one‐third of insurers use a single dealer, whereas other insurers have large dealer networks. Execution prices are nonmonotone in network size, initially declining with more dealers but increasing once networks exceed 20 dealers. A model of decentralized trade in which insurers trade off the benefits of repeat business and faster execution quantitatively fits the distribution of insurers' network size and explains the price–network size relationship. Counterfactual analysis shows that regulations to unbundle trade and nontrade services can decrease welfare.

ABSTRACT Dealer quotes in corporate bonds, though indicative, lower trading costs and increase trading volume. Dealers offering higher quality quotes attract more order flow and execute trades at favorable prices. Dealers advertise quotes to manage their inventories and attract orders from nonrelationship clients. However, quote competition is imperfect. The best quotes often fail to attract orders, and trade‐throughs are common. Nevertheless, quote competition is important as clients exploit quotes from other dealers in negotiations, forcing dealers with lower quality quotes to offer price improvements. Quoting is not a zero‐sum game, as more active bond‐level quoting leads to more bond‐level trading.