Knowledge that Transforms

ABSTRACT The objective evaluation of evidence is imperative for audit effectiveness and the proper exercise of professional skepticism. However, numerous studies suggest that auditors fail to evaluate evidence objectively when assessing or addressing the risk of material misstatement due to fraud. We develop theory to predict that auditors do evaluate evidence objectively but only when they have stronger wise‐thinking dispositions (WTDs), a construct that is new to the audit literature. We define WTDs as the tendency of individuals to naturally engage in the balanced revision of beliefs and doubts about target phenomena by thinking openly and reflectively about evidence. We report prediction‐consistent results from two experiments that measure the strength of participants' WTDs and manipulate whether the underlying evidence is less or more indicative of fraud. The experimental results also document that auditors vary considerably in WTD strength and collectively demonstrate the reproducibility of audit judgment‐quality benefits of stronger WTDs. We further validate the WTD construct in auditing using confirmatory bi‐factor analyses to show that it has one higher‐order general factor along with several subfactors. Overall, our theory and results advance the literature by identifying WTDs as a determinant of auditors' ability to objectively evaluate evidence. In addition, our findings have implications for standard setters and audit firms as quality control standards and audit working paper review processes might benefit from revisions that take into account that auditors do not objectively evaluate evidence unless they have stronger WTDs.

ABSTRACT This paper reports the results of multiple studies that together provide converging evidence in support of the theory that gender stereotypes bias employee selection during group recruiting events. Specifically, we predict and find that female (male) job candidates who exhibit stereotypically male behaviors receive lower (higher) evaluations during group recruiting events, particularly among male recruiters. Prior research suggests gender stereotypes do not bias employee selection during one‐on‐one interviews. However, our results suggest that evaluating job candidates in the more social context of group events can have important unintended consequences on employee selection, a key component of the accounting control environment. Given the importance of group recruiting events to inform hiring decisions across organizations such as investment banks and public accounting firms, our results contribute to a better understanding of survey and field evidence suggesting that entry‐level male and female employees have different personalities at these organizations, which appear to influence their career trajectories.

ABSTRACT We study manufacturing firms' asymmetric inventory investment in response to sales changes. Focusing on the costs of resource adjustment and stockout that likely differ in sales‐increasing and sales‐decreasing periods, we predict and find that inventory investment declines less during periods with sales decreases than it rises during periods with sales increases. We validate this claim by showing that managers' expectations of future demand and desire to avoid inventory stockouts are important determinants of this asymmetry. In addition, we find that asymmetric inventory investment provides useful information for predicting future sales growth, and that both managers' and analysts' sales forecasts are positively associated with the asymmetry. Lastly, we document that forecasts of future sales growth that incorporate asymmetric inventory investment are associated with lower absolute forecast errors than benchmark forecasts. Overall, we highlight the importance of inventory information in understanding managers' resource adjustment and utilization decisions that have implications for forecasting future demand. Our findings on asymmetric inventory management provide new insights to fundamental analysis based on inventory signals.

Institutional cross-owners, specifically institutional investors with significant stakes in multiple firms in the same industry, are becoming increasingly common in the United States. In this paper, we investigate and find that the presence of institutional cross-owners facilitates a firm's financing of its investment opportunities, consistent with institutional cross-owners reducing the adverse selection concerns of those who provide capital for the investment opportunities. We then examine the conditions under which the presence of institutional cross-owners is likely to more significantly reduce adverse selection and thereby have even more of a positive effect on the financing of investment opportunities. We document that relative to transient institutional cross-owners, dedicated institutional cross-owners facilitate more financing of investment opportunities. We also find that institutional cross-owners facilitate the financing of investment opportunities even more for firms with greater dependence on external financing, those with an opaque financial reporting environment, and those with more product market competition. Our paper offers novel insight into how a firm can benefit from the presence of institutional cross-owners.

ABSTRACT Regulators and researchers tend to focus primarily on the risk‐shifting benefits of audit liability insurance. We obtain field data from the US audit insurance industry (16 interviews and 83 survey responses) to examine whether insurers also possess characteristics favorable to transferring their private risk management knowledge to the audit firms they insure. Possessing such characteristics would enable insurers to use their relative knowledge advantage to provide a benefit to audit firms beyond risk shifting. Thus, examining this issue helps broaden our understanding of insurers' role in auditing. We examine our data through the lens of the knowledge transfer theory and find evidence that audit liability insurers have the motivation and capacity to accumulate and transfer risk management knowledge to the audit firms they insure. We find that audit firms, particularly the small resource‐constrained firms (i.e., non–Big 4 and non‐second‐tier), rely on and benefit from their insurers' risk management knowledge. We also find that insurers transfer such knowledge through multiple mechanisms, including free consultative services, policy premium incentives, and continuing professional education classes. Our results highlight the important role of audit insurers as transferors of risk management knowledge to audit firms. Broadly, our results extend knowledge transfer theory and suggest areas for future research in US and international contexts.

ABSTRACT We test the association between CFO effort and the quality of public firms' financial information environments. We evaluate this relation using a measure of CFO leisure consumption—specifically, the amount of golf played—as an inverse proxy for effort. We find a negative relation between CFOs' compensation incentives and golf play, suggesting they exert more effort when they have greater incentives to increase firm value. High CFO leisure consumption is associated with lower earnings quality, less accurate earnings guidance, and reduced CFO conference call participation. Additionally, CFO leisure appears to affect external monitors, as it is associated with greater analyst forecast dispersion and increased audit fees. We do not find similar relations when evaluating the amount of golf played by CEOs, suggesting the unique importance of CFO effort in the financial reporting process.

ABSTRACT We reexamine the positive association between stock option vega and earnings management previously documented by Armstrong, Larcker, Ormazabal, and Taylor (2013; henceforth, ALOT). In contrast to ALOT, prior empirical research and practitioner literature emphasizes earnings management's goals of increasing stock price and reducing volatility. Specifically, we assess whether the association is robust to (i) employing discretionary accruals that are less prone to misspecification, (ii) focusing on a more recent time period, and (iii) including additional controls for period‐specific factors. Our main findings are as follows. First, we fail to find a positive association between vega and earnings management after controlling for performance‐related misspecification in discretionary accruals. Second, we find no association between vega and earnings management in a more recent time period, suggesting the results of ALOT may be sensitive to period‐specific factors. Last, the positive association vanishes when we control for year fixed effects, growth opportunities, or monitoring, suggesting the original results of ALOT's research may be sensitive to correlated, omitted variables. Overall, our results question the extent to which vega incentivizes earnings management. Our results may be of interest to boards of directors in designing executive compensation contracts, to regulators in crafting policies that maintain high levels of financial reporting quality, and to researchers seeking to identify settings where earnings management incentives are most salient.

ABSTRACT Within the context of managerial reporting, the tasks of acquiring and reporting information are logically connected. Although the accounting literature acknowledges their importance, it often treats these tasks as distinct processes. I investigate how the effort exerted to acquire information influences managers' reporting. Managers' information acquisition effort can induce psychological ownership that can lead to a sense of deservingness that increases opportunistic reporting or to a sense of responsibility that reduces opportunism. I predict that the reporting context determines the ultimate effect of information acquisition effort on reporting behavior. I test this prediction with a 2×2 budget reporting experiment. Managers are either endowed with information to report or required to exert effort to earn it, with the latter expected to generate more psychological ownership. In addition, I manipulate the saliency of honesty in the reporting context by framing reporting in terms of a business dilemma (less salient honesty) or an ethical dilemma (more salient honesty). I find that when honesty is less salient, managers build more slack into their report under earned information than endowed information. In contrast, more salient honesty alleviates the effect of earned information on slack. In a supplemental experiment, I find similar results when all managers are endowed with information to report but psychological ownership is manipulated via different firm messaging. These results have important implications for theory and practice. For example, in a less salient honesty context, technological investments that reduce managers' effort needed to acquire information can also help decrease opportunistic reporting.

ABSTRACT Recent amendments to Auditing Standard (AS) 3101 require disclosure of the initial year of the auditor‐client relationship in the audit report. As the standard was being discussed, auditors, clients, and some PCAOB members expressed reservations about the necessity of tenure disclosures and were particularly concerned about disclosing tenure in the audit report. Our purpose is to investigate whether the tenure disclosures mandated by AS 3101 are associated with changes in stakeholder behavior. We predict and find that after the implementation date, ratification votes against the auditor and the probability of subsequent auditor dismissal increase for long‐tenured versus short‐tenured auditors. Results from a path analysis further suggest that the relative increase in dismissal for long‐tenured auditors appears to be influenced directly through tenure disclosures and indirectly through ratification voting. We also predict and find that negotiating power decreases for long‐tenured auditors as evidenced by lower audit fees. Our results are comparable for companies that voluntarily disclosed and companies that did not disclose auditor tenure in their proxy statements prior to the AS 3101 amendment. Overall, our study suggests that mandatory disclosure of auditor tenure in the audit report significantly affects stakeholder behavior. The PCAOB should consider our findings carefully as they evaluate whether AS 3101 is achieving its intended purpose.

ABSTRACT This study examines whether a real production activity measure, firm‐level electricity consumption growth, is useful in detecting firm financial misreporting. Identifying proxies for a firm's underlying financial performance that are not a function of the firm's accounting system is essential for detection of misreporting. We propose that the difference between revenue growth and electricity consumption growth (i.e., growth wedge (GW)) is a useful signal of financial misreporting. Using electricity consumption data for Korean firms from 2006 to 2014, we find that the GW is positively associated with discretionary revenues and accruals and the likelihood of financial misreporting as proxied by accounting restatements, qualified audit opinions, and regulatory enforcement actions. The GW provides incremental information over firm characteristics and earnings management signals examined by prior research. Our findings are robust to a battery of additional tests, including within‐firm and industry comparisons that do not require access to cross‐sectional firm‐level electricity data. Overall, our study documents new evidence on the role of a real production activity measure from an independent reporting entity in detecting financial misreporting. Our evidence speaks to the potential usefulness of real activity metrics in forensic economics.