Knowledge that Transforms

ABSTRACT We examine the causal effects of corporate governance on earnings management using shareholder‐sponsored proposals that pass or fail by a small margin of votes in annual shareholder meetings. This setting provides a causal estimate that overcomes concerns of endogeneity. Specifically, compared with firms whose shareholder proposals fall just short of a majority threshold, firms whose shareholder proposals narrowly pass have similar characteristics but a discretely higher likelihood of implementing improvements in governance. As such, we expect that firms whose shareholder proposals pass the threshold by a small margin exhibit a significantly lower level of earnings management. Employing a regression discontinuity design, we find results that support our expectation based on the propensity to just meet or beat analysts' forecasts by one cent as a proxy for earnings management. In addition, we show that the results are driven by governance changes that increase directors' monitoring. Our results are robust to using discretionary accruals as an alternative measure of earnings management. Collectively, the results suggest that improvements in corporate governance curtail earnings management, and support the underlying premise of regulators that improvements in corporate governance would improve financial reporting.

ABSTRACT This study explores close US congressional elections involving politicians who have influence over the SEC to examine the effect of firms' political connections on their financial reporting. This question is important in understanding the overall effect of political connections on financial reporting. Our difference‐in‐differences tests reveal no evidence that firms experiencing a relative increase in political connections report more opportunistically after close elections in anticipation of preferential treatment by the SEC in its enforcement actions. In contrast, we find evidence that these firms report less opportunistically in response to an increase in their connections with SEC‐influential politicians. Further tests show that our findings are unlikely to be driven by capital market pressure, managerial equity incentives, or corporate governance. Overall, our results are consistent with political connections mitigating opportunistic reporting through enhanced scrutiny by the SEC of politically connected firms' financial reporting. Our findings provide new insights into the interactions among political connections, SEC oversight, and financial reporting by showing how politically connected firms alter their financial reporting in anticipation of differential treatment by the SEC.

ABSTRACT We examine whether the strength of internal control over financial reporting (internal control) reduces the expropriation of resources from the firm by managers and controlling shareholders. Although we have ample evidence from prior literature that internal controls reduce errors in financial reports, it is less clear that they can curb resource extraction, because management may fail to enforce these controls. Exploiting the setting of China, where we have a rich internal control data set and established measures of resource extraction, we provide evidence consistent with internal controls curbing resource extraction on average. In particular, we document a negative association between internal control strength and resource extraction. We also find that the association between internal control strength and resource extraction is weaker in settings where we expect management to have fewer incentives to enforce these controls: within state‐owned firms and within non‐state‐owned firms that have a powerful controlling shareholder. We interpret these results as suggesting that internal controls must both exist and be enforced by management for the controls to safeguard assets. Although the analyses are conducted using Chinese data, we expect the spirit of our findings to generalize to other settings—management can “window dress” internal control procedures while still engaging in undesirable behavior.

ABSTRACT This study examines how managers' use of expectation management is affected by their labor market mobility, which we measure by the enforceability of noncompete provisions in their employment contracts. Exploiting quasinatural experiments, our difference‐in‐differences analyses provide new causal insights to the growing literature on how managers' career concerns affect their disclosure choices. Consistent with a less mobile labor market imposing more pressure on managers to achieve earnings expectations, we predict and find that managers in US states that tightened enforcement of noncompete provisions are more likely to manage analyst expectations downward. We also find that downward expectation management is used to a greater extent than other tools such as real and accrual‐based earnings management. Additional analysis shows that the increase in expectation management is more pronounced for CEOs with lower general skills or shorter tenures, for firms with more independent boards, and for industries that are more homogeneous. Our path analysis suggests a significant link between increased use of expectation management after tightened noncompete enforcement and meeting and beating earnings expectations, which in turn is linked to lower executive turnover. Overall, our findings suggest that expectation management is an important channel through which noncompete enforcement reduces executive labor market mobility. Our study sheds light on the underlying mechanism through which labor market mobility affects disclosure choices and has important implications for both firms and regulators on the use and enforcement of noncompete provisions.

We examine how jurors' negligence judgments and attorneys' out‐of‐court settlements are differently impacted by two features of a materially misstated accounting estimate—the amount of estimate uncertainty and whether the misstated account is disaggregated into its own line‐item or aggregated with other accounts into a single financial statement line‐item. We predict and find that jurors and attorneys react to estimate uncertainty in opposite directions under common conditions. This finding is important because when jurors' judgments and attorneys' settlements differ, research into juror judgments alone may not capture a complete picture of auditor liability because the vast majority of audit litigation is resolved by attorneys in out‐of‐court settlement without ever going to trial. Consistent with attribution theory, results from our first experiment show that jurors hold auditors more responsible for misstatements of lower estimate uncertainty when the misstated account is disaggregated, as opposed to misstatements that are of higher uncertainty and/or aggregated with other, accurate accounts. However, in a second experiment we find that attorneys negotiate auditor settlements under the incorrect assumption that jurors will hold auditors more responsible for failing to prevent misstatements of higher uncertainty. Our results illustrate that accounting research should not focus solely on juror judgments in the study of how specific factors impact auditor liability, and that attorneys would benefit from a better understanding of juror decision making.

ABSTRACT We exploit the staggered introduction of the PCAOB's international inspection program to examine the role that the stringency of public audit oversight plays in shaping US institutional investors' home bias. Analyzing a sample of foreign firms listed in the United States, we evaluate whether US institutional investors hold larger equity stakes in these firms—a longstanding issue that reflects investor portfolio decisions—if their auditors are exposed to the threat of a PCAOB inspection. In a differences‐in‐differences framework, we find that US‐listed foreign firms enjoy an increase in US institutional investors' equity positions after their auditors become subject to PCAOB inspection access. Cross‐sectional analysis implies that the benefit of the PCAOB inspection threat in mitigating US institutional investors' home bias is concentrated in foreign countries without a strict local audit oversight system; active US institutional investors that are known to value accounting transparency; and firms from countries that grant PCAOB access later (after the onset of its international inspection program in 2005). Our evidence suggests that foreign firms become better known in the capital markets under the PCAOB inspection program, which induces US institutional investors to acquire larger equity stakes in US‐listed foreign firms given the lower information asymmetry that ensues under the PCAOB inspection threat.

ABSTRACT Although prior studies provide evidence on the financial reporting incentives to inflate core earnings through classification shifting (e.g., shifting core expenses to income‐decreasing noncore items), few examine the tax‐related incentive to report lower core earnings through classification shifting. We examine the effect of controlling shareholders' tax incentives on firms' classification shifting using the introduction of a tax law in Korea that imposes a gift tax on controlling shareholders based on firms' reported core earnings. This tax law creates incentives for managers to report lower core earnings through classification shifting, even though doing so would incur significant financial reporting costs. Using a difference‐in‐differences research design, we find that firms with controlling shareholders subject to the gift tax exhibit a significant decline in classification shifting in the post‐tax period, while those not subject to the tax do not. We also predict and find that the extent to which managers reduce classification shifting decreases with financial reporting costs and increases with the tax benefits. Overall, our results indicate that firms forgo financial reporting benefits associated with reporting higher core earnings for the tax savings of their controlling shareholders.

ABSTRACT Prior research documents that information transmitted via director networks affects firms' policies and real economic activities. Given a manager's potential monopoly over firm information, it is important to analyze whether information transmission through director social networks undermines the manager's control. Specifically, we explore whether information flow through director networks influences managers' ability to hoard bad news. We predict and find that the extent of external connections of the board of directors is negatively associated with future stock price crash risk. Additional analysis implies that this evidence is driven by firms with more powerful executives, with weaker auditor monitoring, or subject to strong investor protection, and by directors with greater monitoring incentives or responsibilities and directors with less firm‐specific knowledge. Collectively, our research lends empirical support for the monitoring view under which better‐informed directors narrow the scope for bad news hoarding evident in stock price crash risk. In another series of tests, we fail to find evidence consistent with the information leakage view under which directors pass sensitive firm‐specific information to connections that trade on the information before its public release. Other analysis helps dispel the concern that the endogenous match between directors and companies is spuriously responsible for our core results. Our empirical findings have important implications on how social networks affect the proper functioning of capital markets.

ABSTRACT We study three elements of management control: incentive compensation, performance monitoring, and delegation of authority to managers to contract with lower‐level employees. Using a principal‐agent model, we highlight important direct and indirect interactions between and among these endogenous control elements, themes often emphasized in the economics and accounting literatures using the analogy of a three‐legged stool. We identify circumstances in which control elements are complements or substitutes and exhibit a coherent pattern of practices observed together. For instance, contrary to typical predictions that quality monitoring complements steep effort incentives, we find that when contracting authority adjusts easily to changes in firm circumstances, then both incentive pay and contracting authority substitute for monitoring quality, while incentive pay complements contracting authority. Overall, our findings suggest a number of empirical implications and generally inform a growing literature that documents the presence or absence of complementarities among management control elements.

ABSTRACT Starting in October 2013, auditors of premium‐listed firms in the United Kingdom are mandated to prepare an expanded auditor's report that provides details on audit procedures, risks of material misstatement (RMMs), and materiality thresholds. This regulatory change is important to study, because it aims to increase the informational value of the traditional, highly standardized, pass‐or‐fail auditor's report. We examine whether the disclosures in the expanded auditor's report provide information that is relevant for adopting firms' loan contracting terms in the post‐adoption period. Our results indicate that the introduction of the expanded auditor's report is associated with reduced loan spread and longer maturity for loan facilities of adopting firms relative to non‐adopting UK firms. When we focus on adopting firms in the post‐adoption period, we find that the number of “unique RMMs” mentioned in the auditor's report, but not in the audit committee report, are positively associated with loan spread but are not associated either with loan maturity or the number of lenders in the loan syndicate. Additional tests show that the benefits, in terms of a reduced spread, of having a lower number of “unique RMMs” accrue mostly to adopters with a poor information environment. Taken together, our results provide preliminary evidence that the expanded auditor's report disclosures contain relevant information for loan contracting in the United Kingdom. This study highlights the unique role of the expanded auditor's report in providing information relevant to lenders and supports standard setters' efforts to enrich its informational content.