Knowledge that Transforms

ABSTRACT We examine how the extent and distribution of industry knowledge within an audit team affect audit outcomes. While prior research examining the role of auditors' industry knowledge focuses mainly on audit firms, audit offices, and audit partners, audits are conducted by audit teams. Using an audit framework and proprietary data from a Big 4 firm that includes audit hours for each team member, we find that Big 4 audit teams with higher average industry knowledge are associated with more audit effort. In contrast, we find mixed evidence on the relation between the average hourly internal cost rate and team knowledge. Furthermore, we find that balanced teams, which have at least one team member who qualifies as an industry specialist at both the senior rank and junior rank, produce higher‐quality audits than teams that have no specialists. In contrast, the audit quality of unbalanced teams, which have a specialist at the senior rank but not the junior rank or vice versa, is not statistically different than teams with no specialists. Overall, our evidence suggests that both the extent and distribution of industry knowledge within a team matter for audit production and that industry knowledge is utilized more effectively when it is spread throughout the team. The findings have useful implications for audit firms and regulators regarding how team composition and industry knowledge affect audit outcomes.

ABSTRACT This study examines corporate integrity culture—that is, a firm's shared values and behaviors related to compliance, trustworthiness, and ethics. Different from prior research that associates culture measures with general firm‐level outcomes, we evaluate the pervasiveness of the integrity culture within an organization across two disparate business functions: operations and financial reporting. We first develop a measure of corporate integrity culture based on firms' internal control environments and show that, as predicted, weak integrity culture contributes to both operational and financial non‐compliance. We next document the predicted positive contemporaneous association between operational and financial non‐compliance, controlling for the integrity culture reflected in the internal control environment. Given the organizational and physical distances and lack of day‐to‐day interactions between the two business functions, we infer that management's “tone at the top” likely affects non‐compliance in both functions. Finally, for firms with existing operational non‐compliance, we find more negative market reactions to accounting restatements and higher CEO turnover propensities following restatements. These results indicate that top management must consistently reinforce a culture of compliance and integrity, lest it decay throughout the organization. Our results also imply that regulators evaluating compliance in specific functions could benefit from reviewing compliance in other functions within the firm.

ABSTRACT We provide evidence that regulatory guidance aimed at improving audit efficiency and effectiveness—allowing auditor reliance on a multi‐location client's competent and objective internal audit function (IAF)—can unintentionally increase auditors' litigation risk. Our research is important in demonstrating how client characteristics and juror cognitive processing, such as the number of client locations and jurors' susceptibility to the numerosity heuristic, factors beyond auditors' control, can exacerbate their litigation exposure. Consistent with theoretical predictions, we find that susceptibility to the numerosity heuristic contributes to jurors assessing an increased likelihood of misstatement on multi‐location compared to single‐location audits. Furthermore, these assessments of higher misstatement risk on multi‐location audits lead jurors to perceive that auditor reliance on the client's IAF in multi‐location audits is less appropriate (i.e., not normal). Accordingly, jurors judge that auditors are more negligent when they rely on the IAF during multi‐location audits than when they do not, but IAF reliance does not impact auditor negligence on single‐location audits. Our results suggest auditor reluctance to use a qualified IAF, despite client pressure and regulatory allowance, can provide potential benefits to firms in terms of reduced litigation exposure. Thus, we demonstrate the legal regime can undermine the objectives of regulators' guidance to enhance audit efficiency and corporate governance.

ABSTRACT Short selling efficiency (SSE), measured each month by the slope coefficient of cross-sectionally regressing abnormal short interest on a mispricing score, significantly and negatively predicts stock market returns both in-sample and out-of-sample, suggesting that mispricing gets corrected after short sales are executed on the right stocks. We show conceptually and empirically that SSE has favorable predictive ability over aggregate short interest, as SSE reduces the effect of noises in short interest and better captures the amount of aggregate short selling capital devoted to overpricing. The predictive power is stronger during the periods of recession, high volatility, and low public information. In addition, low SSE precedes the months when the CAPM performs well and signals an efficient market. Overall, our evidence highlights the importance of the disposition of short sales in stock markets.

ABSTRACT Many companies regularly disclose non‐GAAP performance measures to communicate firm‐specific information that does not fit within the mold of GAAP reporting. However, these non‐GAAP measures may have low information content or even be misleading to investors. Thus, the question arises of whether auditors should play a larger role in the reporting of non‐GAAP measures, which currently are not audited. We run an experiment to provide ex ante evidence on the effect of auditing non‐GAAP measures. Specifically, we present investor‐participants with a non‐GAAP measure that should be used when making investment judgments (more informative) or should not be used when making investment judgments (less informative) and is either audited or is not audited. As predicted, we find that, when participants view a non‐GAAP measure that is more informative, they appropriately use the non‐GAAP measure in their investment‐related judgments, regardless of whether the measure is audited. However, also as predicted, we find that, while participants appropriately do not use a less informative non‐GAAP measure when it is not audited, participants inappropriately do use the less informative non‐GAAP measure in their investment‐related judgments when it is audited. Mediation results provide evidence consistent with audits affecting investors' reliance on non‐GAAP measures. Specifically, our results are consistent with audits of non‐GAAP measures signaling more than is intended, evidenced by investors perceiving an audited non‐GAAP measure as being useful in their investment decisions when the measure is less informative to them. Our findings suggest that regulators should exercise caution when it comes to prescribing assurance over non‐GAAP measures.

ABSTRACT As part of the Tax Cuts and Jobs Act (TCJA), the US Congress repealed a long‐standing exception that allowed companies to deduct executives' qualified performance‐based compensation in excess of $1 million. The purpose of this study is to examine whether Congress achieved its stated objective of reversing a shift in executive compensation away from cash compensation and toward performance pay, which Congress believed led executives to focus on short‐term results rather than the long‐term success of the company. Across a battery of tests, including a difference‐in‐differences design that exploits the staggered time‐series implementation of the deduction limit, we find evidence compatible with the new deduction limit having no effect on executives' salary, performance pay or total compensation, inconsistent with Congressional intent. Our results suggest that taxes are not a first‐order effect of executive pay and that tax regulation could be relatively ineffective at curbing executive compensation.

ABSTRACT This study investigates whether and how organizations change their use of management accounting during crisis. The study is important because organizations regularly face significant challenges such as crisis during which the role of management accounting is not well understood. Based on interviews and observation in five private sector organizations and one in the public sector, I find that executives in organizations facing crisis due to a discontinuous and unpredictable environmental change leverage management accounting during the crisis. In contrast, executives in organizations facing crisis due to a continuous and predictable environmental change question the truth and value of their management accounting practices and, as a result, do not change their use of management accounting to manage the crisis. For those organizations that do leverage management accounting, I rely on conceptual and empirical insights from the literature examining the decision‐facilitating role of informal management accounting to examine how they adapt or develop new management accounting tools and practices to manage crisis. I find that executives first engage in a comprehensive review of their management accounting systems and reports to convince themselves that they can be relied on. Following this process, they leverage accounting to understand the past, develop metrics intended to reach all employees, and institute various forms of accountability to support the management of crisis. The use of these informal management accounting tools and practices enables organizations to develop a new language for understanding and managing crisis. The primary contribution of my study is that it conceptualizes and theorizes informal management accounting tools and practices as a mechanism that facilitates response to crisis. These tools and practices are low‐cost and easy to implement, which are favorable given the challenges associated with crisis.

ABSTRACT This study examines the impact of control systems on corporate innovation. Innovation is key to firm performance and growth, allowing corporations to stay competitive in their industry. We expect control systems to improve information flows within the firm by allowing managers to better identify and patent their most valuable intellectual property. Despite our prediction that control systems positively impact innovation, a priori, this relation is unclear as these same control systems may create an overly restrictive bureaucratic environment that may mitigate the benefits of effective controls for innovation. Using various measures of control system quality, we find evidence that effective control systems are associated with more innovation. Overall, the results of our study suggest effective control systems are associated with the ability of a firm to leverage its innovative projects. Our results suggest that corporations with effective control systems are more likely to be able to react to market and technology changes by ensuring their best ideas are patented.

ABSTRACT One of the prime responsibilities of the board of directors is to understand and oversee its firm's risk profile. We exploit a recent European Union (EU) regulation, the General Data Protection Regulation (GDPR), as a quasi‐exogenous shock to the cyber risk landscape to assess whether boards of US firms changed their focus and governance structures to deal with this new challenge. The GDPR encompasses a sweeping set of regulations aimed at protecting EU citizens from unwanted uses of their personal Internet data. Although an EU regulation, the GDPR applies to all US public firms with at least one EU user. Adopting a difference‐in‐differences methodology, we use firms that already fall under a US data privacy regulation as a control group and find that boards of treated US firms, on average, increase their focus on cyber risk, add more directors with cyber/IT expertise, and more frequently assign cyber risk oversight to the board or to a board committee. In cross‐sectional tests, we show that these changes are positively associated with a firm's ex ante cyber risk, but are unrelated to whether a firm had a large EU presence, suggesting a more global reaction to the GDPR. In addition, we examine some of the consequences of these board changes. We find boards that promptly responded by changing their board focus, expertise, and monitoring assignment of cyber risk around the passage of GDPR had fewer future cyberattacks/data breaches and less related media attention. Our findings suggest that, on average, American corporate boards promptly responded to changes in the cyber risk environment in ways that reduced their firms' overall future cyber risk. Our results have implications for the efficacy and flexibility of US corporate boards to respond to unexpected changes in risk.

ABSTRACT This study examines whether and how firms' voluntary forward‐looking nonfinancial disclosure, specifically their corporate social responsibility (CSR) disclosure, is associated with the intensity of product market competition (PMC). Despite the importance of the proprietary cost argument in explaining corporate disclosure incentives, there is little empirical evidence of the relationship between firms' proprietary cost concerns and their voluntary nonfinancial disclosure decisions. Using a reduction in industry‐level import tariffs as an exogenous shock to competition intensity, we find that the likelihood, frequency, and length of stand‐alone CSR reports decrease in response to heightened PMC. We also find that higher PMC intensity is associated with a reduced likelihood of CSR disclosure with external assurance, CSR disclosure in accordance with the Global Reporting Initiative guidelines, and CSR disclosure integrated with financial statements. Our results are robust to multiple alternative measures of PMC—namely, the level of nonprice competition, product similarity, and managers' perceptions of competition. Further analysis suggests that firms facing intense competition tend to commit more resources to advertising activities after reducing their CSR disclosure, presumably to mitigate the effect of this reduction. Overall, our findings suggest that proprietary cost concerns reduce firms' incentive to report their competition‐sensitive CSR activities.