Knowledge that Transforms

We investigate the mechanism through which the Sarbanes Oxley Act ( SOX ) was associated with changes in corporate investment strategies. We document that the passage of the governance regulations in SOX was followed by a significant decline in pay‐performance sensitivity (Delta) and incentives to take risk (Vega) in CEO s' compensation contracts. These changes in compensation contracts are related to a decline in investments, including research and development expenditures, capital investments and acquisitions. Moreover, consistent with the rules in SOX directly affecting CEO s' incentives to take risk, we document that the decline in investments exceeds the amount that would be expected from changes in compensation packages alone. Finally, we also find evidence that the changes in investments are related to lower operating performances of firms, suggesting that these changes were costly to investors. Our evidence speaks to the debate on how corporate governance regulation interacts with firms' and managers' incentives, and ultimately affects corporate operating and investment strategies. Our study suggests that one indirect cost of such regulations in SOX is the significant reductions in corporate risk‐taking activities in the post‐ SOX period. The changes in investments were in part due to changes in executive compensation contracts and in part related to increased executives' personal costs of engaging in risky activities.

This paper examines the determinants and economic efficiency of corporate voluntary disclosure. The focus is on the trade-off for an individual firm when the costs and benefits of voluntary disclosure stem from the consequences of its investment decisions and the impact on its share price. Investment and voluntary disclosure decisions are intertwined. First, voluntary disclosure leads to more accurate pricing, which induces more efficient investment decisions. Second, the firm may affect the market pricing in its favor by strategically disclosing or withholding its private information. This opportunistic use of disclosure may cause the real investment to be distorted at the margin. My analysis shows that the efficiency of voluntary disclosure is influenced by both effects. Further, this paper investigates how the investment efficiency and the propensity for providing voluntary disclosure respond to various environmental variables. Two such key variables are the general economic outlook of the investment opportunity and the quality of firm private information.

The issue of whether auditor fees affect auditor independence has been extensively debated by regulators, investors, investment professionals, auditors, and researchers. The revised Securities and Exchange Commission ( SEC ) requirements that resulted from the implementation of the Sarbanes‐Oxley Act (2002) limit nonaudit services ( NAS ) and mandate NAS fee disclosure. The SEC 's requirements are based on the argument that auditor independence could be impaired—and hence audit quality may be reduced—when auditors become economically dependent on their clients or audit their own work. Economic bonding leads to reduced independence, which can lead to reduced audit quality. We study a sample of firms sanctioned by the SEC for fraudulent financial reporting in Accounting and Auditing Enforcement Releases ( SEC ‐sanctioned fraud firms) and examine whether there is a relationship between auditor fee variables and the likelihood of being sanctioned by the SEC for fraud. We use SEC sanction as a measure of audit quality that has not previously been used in the auditor fee literature and is more precise than some of the other proxies used for flawed financial/auditor reporting. We find, in univariate tests, that fraud firms paid significantly higher (total, audit, and NAS ) fees. However, in multivariate tests, when controlling for other fraud determinants and endogeneity among the fraud, NAS , and audit fee variables, we find that while NAS fees and total fees are positively and significantly related to the likelihood of being sanctioned by the SEC for fraud, audit fees are not. These findings suggest that higher NAS fees may cause economic bonding, thereby leading to reduced audit quality. Our findings of significantly higher NAS fees and total fees in fraud firms hold after controlling for latent size effects and other rigorous testing. These results contribute to the literature that examines the SEC 's concerns regarding NAS and can be used by policy makers for additional consideration.

Francis and Yu (2009) and Choi, Kim, Kim, and Zang (2010) report evidence that Big 4 audits are of higher quality when the engagement office is of larger size. Specifically, client earnings quality is higher and auditors in larger offices are more likely to issue going‐concern audit reports. We extend this line of research to test if larger Big 4 offices have fewer client restatements. A client restatement provides more direct evidence of a low‐quality audit than earnings quality metrics or going‐concern reports, because a restatement indicates the client's auditor did not effectively enforce the correct application of GAAP at the time the original financial statements were issued. We analyze 2,557 firm‐year restatements in a sample of 23,190 financial statements originally issued by U.S. firms from 2003 to 2008. We find that Big 4 office size is associated with fewer client restatements after controlling for innate client characteristics that may affect restatements (client size, financial performance, industry membership, nonfinancial measures, off‐balance sheet activities, and market‐related measures), and a set of controls for other auditor factors such as fees and industry expertise. The study raises important questions about the ability of smaller offices to deliver high‐quality audits for SEC registrants.

This study examines whether mandatory adoption of International Financial Reporting Standards ( IFRS ) leads to capital market benefits through enhanced financial statement comparability. U.K. domestic standards are considered very similar to IFRS , suggesting any capital market benefits observed for U.K.‐domiciled firms are more likely attributable to improvements in comparability (i.e., better precision of across ‐firm information) than to changes in information quality specific to the firm (i.e., core information quality). If IFRS adoption improves financial statement comparability, we predict this should reduce insiders' ability to benefit from private information. Consistent with these expectations, we find that abnormal returns to insider purchases ― used to proxy for private information ― are reduced following IFRS adoption. Similar results obtain across numerous subsamples and proxies used to isolate IFRS effects attributable to comparability. Together, the findings are consistent with mandatory IFRS adoption improving comparability and thus leading to capital market benefits by reducing insiders' ability to exploit private information.

Abstract Previous empirical studies derive the standard equity valuation models (i.e., DDM, RIM, and DCF model) while assuming that ideal conditions, such as infinite payoffs and clean surplus accounting, exist. Because these conditions are rarely met, we extend the standard models by following the fundamental principle of financial statement articulation. We then empirically test the extended models by employing two sets of forecasts: (1) the analyst forecasts provided by Value Line, and (2) the forecasts generated by cross‐sectional regression models. The main result is that our extended models yield considerably smaller valuation errors. Moreover, by constructing these models, we obtain identical value estimates across the extended models. By reestablishing empirical equivalence under nonideal conditions, our approach provides a benchmark that enables us to quantify the errors caused by individual deviations from ideal conditions and thus to analyze the robustness of the standard models. Finally, by providing a level playing field for the different valuation models, our findings have implications for other empirical approaches, for example, estimating the implied cost of capital.

We study whether Section 404 of the Sarbanes-Oxley Act of 2002 made cross-listed firms less opaque via an examination of analyst earnings forecasts. To test this, we compare European Union (EU) firms that are cross-listed in the US—and therefore subject to S404—with comparable EU firms that are not cross listed. We find that while both types of firms experienced a decrease in opaqueness over time, this decrease was significantly larger for cross-listed firms. Our results are robust to accounting for concurrent sell-side analyst regulations in the US, delistings, and changes in corporate risk taking. Overall, our analysis suggests that SOX had a positive effect on corporate disclosure quality.