Knowledge that Transforms

We examine whether management faultlines (i.e., dissimilar groupings among executives) are related to management forecast processes and outcomes. Management faultlines are formed based on the simultaneous alignment of senior executives' demographic characteristics (e.g., an MBA background, elite school education, gender, board experience, age, or tenure). We argue that management faultlines impede information sharing, create conflicts, and divert managerial attention away from common‐goal tasks. We hypothesize and find that management faultlines are associated with lower management forecast quality. Furthermore, the faultline effect is more pronounced when forecasting difficulty is high. In contrast, the faultline effect is mitigated when a firm nurtures a supportive and diverse workplace. In addition, we find that management forecast propensity and frequency are negatively associated with management faultlines. Overall, our findings suggest that management faultlines compromise management forecast processes and outcomes. In particular, since faultlines can arise as a company diversifies, boards should be aware of these unintended consequences and how they can be mitigated.

Many studies use GAAP effective tax rates (ETRs) as a proxy for tax avoidance and assume that very low (high) ETRs represent the greatest (least) tax avoidance, yet ETRs can be affected by items unrelated to tax avoidance. Despite awareness of the potential limitations of ETRs versus other factors as a measure of tax avoidance, the literature lacks consistent evidence on the extent to which ETRs capture tax avoidance. We take a step toward filling this void using income tax footnote disclosures from 2008 through 2016 to investigate how well ETRs versus other factors capture cross‐sectional differences in tax avoidance. We document that ETRs below 5% and above 40% are significantly influenced by items largely unrelated to tax avoidance, such as valuation allowances and goodwill impairments. Truncating ETRs at zero and one, controlling for standard determinants of tax avoidance, and using industry‐size‐adjusted ETRs or multiyear GAAP ETRs do not eliminate the clustering of factors largely unrelated to tax avoidance in the tails of the ETR distribution. Cash ETRs attenuate but do not eliminate this clustering. Researchers can use ETR rate reconciliation data to construct an adjusted ETR that removes the influence of factors largely unrelated to tax avoidance. Our findings inform researchers about factors largely unrelated to tax avoidance that drive significant deviations in ETRs from the statutory tax rate. This is of increasing importance as the number of studies examining the consequences of very high and very low ETRs grows.

This study provides evidence that hedge accounting information under Statement of Financial Accounting Standards (SFAS) 133, Accounting for Derivative Instruments and Hedging Activities , is related to rivals' market entry decisions. Documenting accounting information's relevance to competition decisions requires context‐specific settings. Using data for the airline industry in the United States, I predict and find that entrants are less likely to enter routes in which incumbents report higher accumulated other comprehensive income from fuel hedging, an indication of lower future operating costs. As predicted, this relation is stronger after the adoption of SFAS 161, Disclosure about Derivative Instruments and Hedging Activities , in 2008, a systemic shock that significantly increases risk management disclosure requirements. The findings illustrate the product market relevance of hedge accounting signals and disclosure in the US airline industry and extend the understanding of SFAS 133 and SFAS 161 beyond the capital markets.

Errors reflect unintended deviations from plans or goals and commonly carry negative connotations. Although errors cannot be eliminated, they offer opportunities for learning and innovation. Audit firms employ powerful mechanisms, such as review processes, to prevent or detect audit errors and safeguard their work in the public interest. At the same time, the profession recognizes positive long‐term outcomes of errors in terms of continuous learning to enhance auditor skills and, ultimately, audit quality. The current study employs semistructured interviews with Dutch auditors to investigate how they manage the tensions emanating from extant public and regulatory demands for flawless audits while embracing errors as opportunities for learning. Our findings reveal that auditors express a positive attitude toward openly communicating audit errors, but, in substance, they espouse negative emotions and defensive strategies for fear of repercussions. We argue that the excessive emphasis audit firms and oversight bodies place on error prevention conditions auditors into perceiving errors as negative and avoidable events. We assert these attitudes result from the profession's efforts to maintain status and legitimacy in the eyes of the public and the regulator, where any auditor error may shed doubt on auditors' work in the public interest. In sum, our findings indicate that viewing errors as incompatible with audit work makes the profession susceptible not only to repeating errors but also to missing out on opportunities to improve services and to achieve innovation.

Trading volume is increasingly shifting to dark venues, and the causes of this move are not well understood. We examine whether a firm's reporting opacity affects its dark pool trading and provide robust evidence that (partly) explains this volume migration. Exploiting the exogenous variation in home‐country reporting opacity in a sample of American Depositary Receipts (ADRs) and using multiple metrics for reporting opacity, we find that greater opacity associates with increased dark pool trading. This relation holds after controlling for firms' information environments, country‐specific governance issues, observable differences between ADRs and other securities that trade in dark pools (matched sample analysis), volume migration to dark pools during earnings announcements, informed trading in lit versus dark venues, ADR levels, IFRS reporting requirements, and the possible endogenous determination of home‐country reporting opacity and dark pool volume. The positive relation is stronger for ADRs held by (quasi‐indexing) institutions with low turnover and diversified holdings and weaker for ADRs favored by (transient) institutions that trade frequently and (dedicated) institutions that hold concentrated portfolios. Bid‐ask spreads are greater for higher opacity ADRs that trade in dark pools, indicating that reporting opacity is associated with the negative effect of dark pool trading on market quality. Our findings help inform the current debate on off‐exchange trading by showing how reporting regimes affect the trading venue choice.

This paper examines the relation between the dispersion in pay‐performance sensitivities (PPS) among top management team (TMT) members and earnings quality. Prior research suggests that the PPS from executives' equity compensation induce earnings manipulation incentives. Most of this research, however, focuses on the PPS of individual executives, even though the financial reporting process requires the coordination among a broad range of executives. Focusing on the dispersion in PPS among TMTs, we develop a model that shows that, due to the coordination incentives embedded in compensation arrangements, managers with more closely aligned PPS will be more willing to work together to manipulate earnings as the rewards are shared more evenly among them. We empirically test the implications from our model and find a positive relation between PPS dispersion and earnings quality. We further find that the stock price reaction to firms' reported earnings relates to the earnings manipulation incentives based on PPS dispersion. Our results suggest that differences in PPS among TMT members hamper the coordination necessary to manipulate earnings and that investors are aware of this impact. Our study has important implications related to compensation‐related disclosures (e.g., those under section 953a of the Dodd‐Frank Act of 2010) and their potential impact on investors' understanding of earnings quality.

Economists broadly agree that the economic burden of corporate taxes is not entirely borne by shareholders but also borne in part by employees and consumers. We examine corporate tax avoidance in a setting where shareholders do not bear the entire economic burden of the corporate tax. We show that the relation between corporate tax incidence and corporate tax avoidance depends on the elasticity of labor supply, the productivity of capital relative to labor, and the tax deductibility of labor and capital. These forces operate through two channels ( firm scale and input mix ), making the actual association between tax avoidance and incidence an empirical question. We find that firms whose shareholders bear less of the economic burden of corporate taxes engage in less avoidance. Our findings suggest that maximizing after‐tax profits might entail less tax avoidance if shareholders do not entirely bear the corporate tax burden. In particular, when the incidence of the corporate tax falls on the firm, firms avoid more taxes. This tendency is stronger if firms use a higher level of capital input, if the deductibility of the cost of capital investment is limited, if firms have high capital productivity, or if tax enforcement is strong.

We conduct two experiments to investigate the joint effect of two justification factors of earnings management—namely, attribution for the firm's underperformance and benefits accruing to other employees from inflating reported earnings. This investigation is important because prior research examines the effects of individual justification factors, whereas real‐world settings entail more complexity involving multiple justification factors. In Experiment 1, we predict and find that managers are more likely to manage earnings when the firm's underperformance is caused by an external event and misreported earnings benefit other employees besides the reporting manager. Furthermore, we show that the extent to which participants use moral justifications mediates the effect of benefits sharing on earnings management, but only when causal attribution is external, and that it mediates the effect of causal attribution on earnings management, but only when benefits are shared. In Experiment 2, we use a neutral control condition that makes no mention of inconsistent incentives to demonstrate that it is the combination of causal attribution and benefits sharing that triggers earnings management. We contribute to the accounting and psychology literature by proposing and testing a theory that explains how multiple justification factors interact to cause opportunistic behavior. Our results suggest that policy‐makers and governing parties should consider developing a holistic view of possible justification factors, focusing on situational opportunities created by combinations of factors rather than individual factors alone.

Does personal litigation risk for independent directors materially affect firm valuation, compensation‐related issues for independent directors, and board composition decisions? We use the unexpected In re Investors Bancorp decision in 2017 by the Delaware Supreme Court, which lowered the liability threshold only for directors in derivative litigation over their own equity grants and increased their future litigation risk, to examine these issues. Understanding changes in independent director litigation risk is important because such changes may affect directors' willingness or ability to serve on boards and advise executives. Consistent with our predictions, investors and firms reacted to the decision. First, Delaware firms experienced significant negative short‐window returns, concentrated in high‐litigation‐risk firms where equity compensation is most important. Second, Delaware firms responded by increasing the use of director compensation caps, highlighting that they did not pay excessive amounts. Third, Delaware firms with higher abnormal director compensation decreased director compensation, while those with lower abnormal director compensation did not. Finally, Delaware firms added higher‐quality directors to the compensation committee, consistent with concerns about heightened litigation risk for those positions. Notably, these new, higher‐quality directors did not accept lower pay, unlike holdover directors who previously served on the committee. Overall, results are consistent with director litigation concerns having a significant effect on shareholder value and firm and director behavior.

Unlike prior research that focuses on determinants of firm-specific stock price crashes (SPCs), we study the consequences of SPCs on market information efficiency. The tension underlying our research question stems from two competing explanations. As an unanticipated shock, an SPC could stimulate (distort) information efficiency by triggering investor rational attention (opinion divergence). Our identification strategy involves a difference-in-differences analysis in which SPC firms in the treatment sample are propensity score matched with non-SPC firms in the industry-peer control sample, as well as placebo tests for falsification. Consistent with the stimulation effect, we find an increase of the earnings response coefficient and a decrease in post-earnings announcement drift, from the pre- to post-SPC period, for SPC firms, but not for non-SPC firms. Further analyses reveal that SPC firms attract increased investor attention, as reflected in greater analyst coverage and more investor access to firms' online financial filings following such an event. Using mutual fund flow redemption pressure based on hypothetical sales as an exogenous shock to SPCs, we provide evidence corroborating our causal interpretation of the main findings. Collectively, the evidence suggests that SPCs can attract increased investor attention, bringing about positive externalities by stimulating market information efficiency.