Knowledge that Transforms

Although it has always been important for firms that employees innovate predefined processes, the working environment in which employees implement these processes has significantly changed. Currently, the working environment is often characterized by employee surveillance; that is, the way in which employees conduct a process is monitored. In the current study, we present the results of an experiment examining the effect of process monitoring on process improvements by employees. Although previous accounting literature has reported negative effects of monitoring techniques on several organizational outcomes, we show that process monitoring can have a positive effect on employees' implementation of process improvements in the absence, but not in the presence, of a firm's error avoidance policy. Without an error avoidance policy, employees are motivated to create a favorable impression in front of management by implementing process improvements. This finding has important implications for business practice. From a broader perspective, we show that the influence of action controls depends on the parameters of a cultural control.

Reciprocity plays a critical role in the way employees respond to managerial control decisions. The current consensus is that employees punish managers for implementing unkind controls (negative reciprocity) more than they reward managers for implementing kind controls (positive reciprocity). We challenge this consensus. Prior research focuses on settings that emphasize employees' immediate reciprocal responses. However, in the workplace, employees often respond over long periods of time to sticky control decisions (e.g., budgets, pay, decision rights). Focusing on these long‐term settings, we predict and find that, while negative reciprocity is initially stronger than positive reciprocity, it also fades more over time than positive reciprocity. This differential fading is so pronounced in our setting that positive reciprocity is stronger overall in the long run. Thus, in long‐term settings, positive responses to kind controls may play a more important role than negative responses to unkind controls. Our results inform managerial decisions about the use of kind versus unkind controls and suggest potential long‐term benefits of pay disparity and other policies that treat employees differentially.

We analyze whether and how the perceived federal‐level legal liability linked to federal judge ideology is associated with the likelihood of firms receiving going‐concern modified audit opinions and analyze the differential effects on Big 4 and non–Big 4 auditors. We find that Big 4 and non–Big 4 auditors converge in their going‐concern reporting decisions in circuits with more liberal judges. This convergence is caused by the greater effect of judge ideology on non–Big 4 auditors. Furthermore, we empirically examine the association between federal judge ideology and actual lawsuits against auditors and find that judge ideology has a greater impact on lawsuit likelihood for non–Big 4 auditors for the restating companies. When auditors are sued, both the payout likelihood and amount are greater in circuits with more liberal judges, with the effect being more pronounced for non–Big 4 auditors. This study provides evidence on how the perceived exposure to a gross negligence legal standard shapes auditors' going‐concern reporting incentives for the two tiers of auditors in the market. It also adds to the literature on auditor litigation.

Granting decision rights to minority shareholders protects them from expropriation by controlling shareholders, but it simultaneously fosters a mismatch between decision rights and decision‐relevant information. Using the setting of China's classified voting system (CVS), which requires minority shareholder approval for managerial proposals, this study investigates the effect of such a regulation on investment responsiveness to profitability and equity value attributable to growth options. Following the real‐options‐based valuation model, we document that the adoption of CVS diminishes both investment responsiveness and equity value. This reduction is attributed to heightened financial constraints following the CVS implementation. Further analyses show the negative impacts are more pronounced for firms experiencing greater information asymmetry, lower mutual fund holdings, and severe agency conflicts. Our evidence indicates that the efficacy of the regulation is contingent on the alignment between decision rights of minority shareholders and decision‐relevant information available to them. Our findings thus provide insights to the regulators regarding the advantages and disadvantages of allowing minority shareholders direct influence over corporate decision‐making.

We examine how progressive individual tax rates affect risk‐taking by pass‐through businesses (PTBs). PTBs generate over 60% of US business income and make up roughly 95% of business tax returns, yet there is limited research on how progressive tax rates affect project selection. We study PTBs using the setting of thoroughbred racing and examine how progressive tax rates affect the decision to enter a risky stakes race or a less risky allowance race. This setting provides a unique opportunity to observe the choice between two mutually exclusive projects that differ only in expected payoffs and risk. Using a difference‐in‐differences design surrounding the reduction in progressivity under the Tax Cuts and Jobs Act, we find that investment in stakes races increases in the United States relative to Canada. We find further evidence of a negative relation between progressive tax rates and risk‐taking using a plausibly exogenous shock in progressivity in California and exploiting cross‐sectional variation in the progressivity of state tax rates. Overall, our findings should be of interest to policy‐makers considering changes to progressive rates. Results indicate that increases to progressive tax rates may discourage risk‐taking by the small businesses that drive economic growth.

We examine whether auditor political connections are associated with the SEC's oversight of audit clients . Specifically, we test whether auditors' political action committee contributions are associated with three SEC oversight actions: comment letters, investigations, and Accounting and Auditing Enforcement Releases (AAERs). Consistent with higher political connections inducing heightened scrutiny from the SEC, we find that the clients of auditors with higher political connections are more likely to receive comment letters and face SEC investigations. However, conditional on SEC investigation, we find no association between auditor political connections and the issuance of AAERs. We consider heightened attention from investors and analysts toward audit clients as one possible mechanism leading to increased SEC scrutiny because auditor political connections could be perceived as a red flag. Using EDGAR downloads and the number of earnings forecast revisions, we document evidence consistent with the existence of this mechanism. These findings add to our understanding of how auditor political connections could influence SEC oversight over audit clients.

We examine the effect of product market competitors' listing delays on incumbent firms' defensive strategies, including efforts in customer retention and acquisition as well as merger and acquisition (M&A) activities. To establish causality, we use four regulation‐induced IPO suspensions in China that expose firms already approved for an IPO to indeterminate listing delays. Using a difference‐in‐differences design, we find that incumbent firms reduce efforts in customer retention and acquisition, as manifested in an increase in accounts receivable turnover and a decrease in selling expenses. Incumbent firms also reduce M&A activities, including high‐premium and horizontal ones. The effects are stronger for incumbent firms that are subject to more intensive competition from the suspended firm, face larger competitive pressure from existing public firms, and are more financially constrained. Additionally, incumbent firms' managers reduce competition‐related disclosures, and the firms' financial performance improves after competitors' listing delays. Consistent with the findings based on listing delays, we find that incumbent firms increase efforts in customer retention and acquisition and M&As surrounding competitors' IPO application and approval. Our paper sheds new light on the IPO peer effect, especially on how incumbent firms respond to the product market competitor's capital market entry.

Securities litigation risk is a well‐recognized yet underexplored source of financial reporting complexity or unreadability. This study examines the effect of litigation risk on the readability of corporate financial reports. The 1999 Silicon Graphics Inc. (SGI) court ruling unexpectedly reduced litigation risk for firms within the Ninth Circuit Court's jurisdiction. Using a difference‐in‐differences design centered on the SGI court ruling, we find that, while the readability of financial reports generally declines over the sample period, treated firms in the Ninth Circuit experience a comparatively smaller decline in readability than control firms in other states after the ruling. Put differently, treated firms experience a relative improvement in reporting readability following the ruling. This effect is concentrated among firms prone to securities litigation and those with greater external financing needs, but it is muted for firms engaging in earnings management. Furthermore, improved reporting readability among treated firms can be partially attributed to alleviated concerns about the adequacy of cautionary language, as evidenced by a significant decrease in negative forward‐looking statements, particularly risk‐related ones. Collectively, our findings suggest that securities litigation risk contributes to reduced readability in financial reporting.

This paper examines whether the sensitivity of local government credit ratings to external signals about the local economy varies with the quality of the governments' financial reports. We find the credit ratings of local governments that are required to comply with GAAP are less sensitive to changes in local home values than similarly affected governments that are not required to comply with GAAP. Further, we show that GAAP's moderating role increased after Governmental Accounting Standards Board (GASB) 34 substantially improved the quality of GAAP‐compliant governments' financial reports, which helps to attribute the main findings to reporting quality. To understand the mechanism, we study positive and negative economic signals separately. The results are pronounced when the change in home values is negative, consistent with reporting quality decreasing the rating agency's uncertainty about local governments' preexisting likelihood of default. We conclude that credit rating agencies are less sensitive to local economic signals when the local government's financial reports are of higher quality.

Financial reporting fraud continues to cost companies millions of dollars annually and is a major source of concern for regulators, stakeholders, and auditors. While academic research has largely focused on external auditors' fraud detection efforts, we analyze whether auditors can help prevent occurrences of fraud through low‐cost reputational signals of higher “strategic reasoning”; strategic reasoning refers to strategies that individuals take in light of the anticipated actions of others (see van der Hoek et al., 2005, A logic for strategic reasoning, AAMAS '05, 157−164). Specifically, we consider the potential impact on manager behavior of signaling whether audit professionals use zero‐, first‐, and second‐order audit approaches. Zero‐order audit approaches involve making decisions based mostly on the auditor's incentives, first‐order approaches involve decisions based mostly on the client's incentives, and second‐ or higher‐order audit approaches involve decisions based on the client's incentives while recognizing that the client will respond to the auditor's decisions (see Wilks & Zimbelman, 2004, Accounting Horizons , 18 (3), 173–184). Using a context‐rich experiment in which manager participants have no history of interacting with the auditor, we find that the likelihood of fraud occurring is lower when it is signaled that audit partners and their teams use a first‐ or second‐order strategic audit approach compared to a zero‐order approach, due to an increase in the perceived likelihood of the auditor detecting fraud. We also consider whether signaling an auditor's level of strategic reasoning influences the level of effort used to conceal fraud and find an increase in the expected level of fraud effort for managers in the first‐ and second‐order audit conditions.