Showing papers in "Contemporary Accounting Research in 2011"

Do CFOs Have Style? An Empirical Investigation of the Effect of Individual CFOs on Accounting Practices*

Abstract: What factors impact the accounting choices of a firm? Numerous prior studies in accounting have examined this question, focusing on various firm-level (e.g., Klein 2002) and marketlevel characteristics (e.g., Leuz, Nanda, and Wysocki 2003) that impact accounting outcomes (see Fields, Lys, and Vincent 2001). The purpose of this paper is to consider another potential influence on accounting choices: manager-specific factors. In particular, we focus on chief financial officers (CFOs) because the CFO typically oversees the firm’s financial reporting process and therefore he ⁄ she likely has the most direct impact of all the senior managers on the accounting related decisions of the firm, such as choosing accounting methods and making accounting adjustments (Mian 2001; Geiger and North 2006; Gore, Matsunaga, and Yeung 2008). We examine whether accounting choices are influenced by differences in CFOs’ individual characteristics that arise from numerous factors including their dispositions, personal situations and prior experiences. Certainly the opening quote of the paper would suggest such a possibility. For expositional purposes, we label these differences CFO style and examine whether CFO style impacts accounting choices. Built on the premise of bounded rationality, research in judgment and decision making has long recognized that individual characteristics play a role in decision outcomes (Bonner

Effects of Audit Quality on Earnings Management and Cost of Equity Capital: Evidence from China†

Abstract: We examine the effects of audit quality on earnings management and cost of equity capital for two groups of Chinese firms: state-owned enterprises (SOEs) and non-state-owned enterprises (NSOEs). The differences in the nature of the ownership, agency relations and bankruptcy risks lead SOEs to have weaker incentives than NSOEs to engage in earnings management. As a result, the effect of audit quality in reducing earnings management will be greater for NSOEs than for SOEs. In addition, investors’ pricing of information risk as reflected in the cost of equity capital will be more pronounced for NSOEs than for SOEs with high and low audit quality. We find empirical evidence consistent with these hypotheses. Our findings indicate that (1) while high-quality auditors play a governance role in China, that role is limited to a subset of firms, and (2) even under the same legal jurisdiction, the effects of audit quality (in the form of lower earnings management and cost of equity capital) vary across firms with different ownership structures. Our study extends prior research by focusing on the economic consequences of SOEs’ and NSOEs’ auditor choices and underscores the importance of controlling for ownership type when conducting audit research.

CEO ability and management earnings forecasts

Abstract: We examine the relation between CEO ability and management earnings forecasts. Trueman (1986) theorizes that high ability managers use forecasts to...

Voluntary Audits and the Cost of Debt Capital for Privately Held Firms: Korean Evidence*

Abstract: Using a large sample of privately held Korean companies that are not required to obtain an external audit, this paper examines the informational value of voluntary external audits of financial statements with respect to the cost of debt. We find that private companies with an external audit pay a significantly lower interest rate on their debt than do private companies without an audit. Further, the interest rate on borrowing is significantly lower for Big 4-audited companies than for non-Big 4-audited companies. Finally, we find that a change in a company’s status from no audit to being audited – either voluntarily or because the audit became mandatory leads to significant savings in the cost of borrowing.

Trading Volume Around Earnings Announcements and Other Financial Reports: Theory, Research Design, Empirical Evidence, and Directions for Future Research*

Abstract: This paper reviews, synthesizes, and critiques the capital market literature examining trading volume around earnings announcements and other financial reports. Our purposes are to assess what we have learned from examining trading volume around these announcements and to suggest directions for future research. We conclude that researchers have yet to realize the potential Beaver (1968) identified for trading volume to yield unique insights regarding the nature of earnings announcements and other financial reports, and the effects of these announcements on market participants. This state of the literature is attributable to a dearth of volume theory early on, and more recently to a disconnect between theoretical development and empirical research. Thus, we begin by briefly summarizing developments in trading volume theory since Beaver (1968). We also discuss unique measurement challenges in trading volume research, including identifying appropriate proxies for abnormal trading volume and for individual investors’ beliefs. In light of theory and empirical measurement issues, we interpret the current literature and identify directions for future research. We conclude that extant research just scratches the surface of what trading volume can reveal about the characteristics of financial disclosures and the effects of these disclosures on investors.

CEO Involvement in Selecting Board Members, Audit Committee Effectiveness, and Restatements

Abstract: Research finds that independent audit committees and audit committee financial experts are generally effective in monitoring the financial reporting and auditing processes. However, not all audit committees that appear in form to be independent are in fact actually independent, and not all financial experts with similar backgrounds and credentials are equally effective. We examine whether the benefits of having an independent and expert audit committee are diminished when the chief executive officer (CEO) is involved in the selection of board members. Using restatements, our results provide some evidence that the monitoring benefits of having an independent and expert audit committee are only maintained when the CEO is not formally involved in selecting board members. Further, we find that these results appear to be driven by the more severe restatements, including misstatements in conjunction with fraudulent financial reporting. In addition, we find our results continue to apply in the post-SOX period – a period that provides data for a more exact measure of CEO involvement in the director selection process, although these data have more limited variation in audit committee characteristics. Finally, we find that the stock market’s negative reaction to a restatement announcement is mitigated only when the audit committee is independent and the CEO was not involved in selecting board members.

Changes in Corporate Governance Associated with the Revelation of Internal Control Material Weaknesses and Their Subsequent Remediation

Abstract: The revelation of material negative events about a firm, including issues such as fraud, restatements, or internal control material weaknesses (ICMWs), may destabilize the firm’s corporate governance equilibrium as it works to remediate the event or effects thereof. Prior research investigates the association between the revelation of fraud and restatements and both board and management turnover. We extend that research, proposing and testing a conceptual model of the process that firms use to remediate negative events in general and ICMWs specifically, with a focus on the role of governance structure changes. Using a sample of 733 firms revealing an ICMW compared to 3,602 firms with unqualified internal control reports, results reveal a positive association between disclosure of ICMWs and subsequent turnover of members of boards of directors, audit committees, and top management. Focusing on the ICMW sample and comparing the 511 firms that remediate their ICMWs to the 222 firms that do not, results illustrate a positive association between remediation of ICMWs and improvements in the characteristics of boards of directors, audit committees, and top management. Data Availability: Data are publicly available from sources identified in the paper.

The case of sustainability assurance: constructing a new assurance service

Abstract: This paper presents an in-depth longitudinal case study examining the processes through which practitioners in two Big 4 professional services firms have attempted to construct sustainability assurance (independent assurance on sustainability reports). Power’s (1996, 1997, 1999, 2003) theorization of the way in which new subject areas are made auditable is used to frame the findings. The case analysis reveals the fragile nature of efforts to innovate with sustainability assurance and render sustainability reporting auditable. It suggests that innovation in new assurance practices may be constrained by an over-reliance on traditional financial audit training and techniques and certain internal professional services firm control procedures. Practitioners are shown to have experienced considerable discomfort in their attempts to construct a stable and legitimate knowledge base for assurance practice. Tacit knowledge embedded in highly subjective assessments of evidence has been frequently enrolled to make assurance possible in the presence of vague guidance from assurance standards. In light of ongoing practitioner struggles, both firms have publicly acknowledged the limitations of traditional financial audit practice operating alone in the conduct of sustainability assurance. In order to offset these limitations, they have proposed a coupling of ‘‘expert’’ stakeholder assessments of reporting completeness with traditional audit assessments of data reliability. This assigns part of the responsibility for delivering on a key assurance objective (reporting completeness) to what many practitioners perceive as questionable stakeholder expertise. The findings extend prior research highlighting the trial and error nature of the processes through which accountants seek to develop their presence in new markets for their expertise. They also question the extent to which the core aims being espoused for sustainability assurance can be substantively aligned with the operational capabilities available within Big 4 professional services firms.

The Relation between Expected Returns, Realized Returns, and Firm Risk Characteristics

Abstract: Existing literature employs two general approaches to assess the validity of alternative proxies for firm-specific cost of equity capital or expected return (hereafter Et)1(rt)). The first approach involves examining the association between the proxy for Et)1(rt) and future realized returns. The second approach focuses on the association between the Et)1(rt) proxy and contemporaneous risk characteristics of firms. The results of these two streams of literature are mixed. Easton and Monahan (2005) (hereafter EM) and Guay, Kothari, and Shu (2005) (hereafter GKS) focus on the association between alternative proxies for Et)1(rt) and future realized returns and conclude that none of the proxies they examine provide valid estimates of the construct of interest. In contrast, Botosan and Plumlee (2005) (hereafter BP) conclude that two common proxies for Et)1(rt) — rDIV (Botosan and Plumlee 2002) and rPEG (Easton 2004) — are valid, based on their finding that both are associated with firm-specific risk characteristics in a theoretically predictable and stable manner. Furthermore, Pastor, Sinha, and Swaminathan (2008) document a positive association between market-level implied cost of capital and risk as measured by the volatility of market returns, consistent with the estimates capturing time-varying Et)1(rt). In this paper, our goal is to reconcile the conflict between these two streams of literature and provide additional evidence pertaining to the construct validity of the proxies employed in extant research. Contrary to the results documented in EM and GKS, we document a positive association between ten of the twelve Et)1(rt) proxies included in our study and future realized returns after controlling for new information. 1 We reconcile our findings to those in EM and GKS by demonstrating that the prior results are due to empirical misspecification. Finally, we show that two of the proxies, rDIV and rPEG, demonstrate not only the expected relation with future realized returns, but also with firm-specific risk. We also address several other issues regarding the use of implied cost of capital estimates including: (1) analysts’ forecast bias, (2) the efficacy of realized returns for Et)1(rt) before and after controlling for news, (3) the effectiveness of averaging several Et)1(rt) proxies, and (4) the substitution of realized values for analysts’ forecasts of cash flows or earnings. Our evidence suggests that deviations between analysts’ expectations and those of the market lead to potentially less powerful proxies but do not generate biased or * Accepted by Steven Salterio. We gratefully acknowledge the financial support of the David Eccles School of Business. We also wish to thank Kin Lo, K. Ramesh, Matt Magilke, and the workshop participants at the

Do Auditor-Provided Tax Services Improve the Estimate of Tax Reserves?*

Abstract: CRISTI A. GLEASON, University of IowaLILLIAN F. MILLS, University of Texas at Austin1. IntroductionWe investigate whether auditor-provided tax services (ATS) improve the estimate of taxreserves. ATS could provide auditors with superior knowledge that would improve thequality of the audited financial reports, or they could impair auditor independence.

Information Externalities along the Supply Chain: The Economic Determinants of Suppliers’ Stock Price Reaction to Their Customers’ Earnings Announcements*

Abstract: We study the economic determinants of the information externality suppliers experience at the time of their customers’ quarterly earnings announcements (QEAs). We measure the information externality as suppliers’ stock price reaction to their customers’ QEAs. We expect information externalities to arise because the information revealed in customers’ QEAs can revise investors’ expectations about the level of suppliers’ future earnings and cash flows, and or because it resolves uncertainty about those future earnings and cash flows. We find that the information externality experienced by suppliers is increasing in the: (1) magnitude of the new information disclosed at customers’ QEAs; (2) strength of the economic bond between the firms, (3) components of the earnings information disclosed by a customer, (4) level of macroeconomic uncertainty prevailing at the time of customers’ QEAs; and decreasing in suppliers’ earnings persistence. We also find that the information contained in customers’ QEAs leads to both a revision in beliefs about the level of suppliers’ future earnings, as well as to a resolution of uncertainty about such earnings. Our study adds to the literature which seeks to understand the economic factors that lead to cross-sectional differences in earnings informativeness. However, unlike prior studies which have focused on examining the factors that determine “own-firm” stock price reactions to earnings, we identify the economic factors that lead to cross-sectional differences in the informativeness of one firm’s earnings (e.g., a customer’s) to investors of a another, non-announcing firm (e.g., a supplier). Our study also extends prior research by documenting that information externalities are not limited to firms in the same industry but also extend to firms in the supply chain.

Aggregate quasi rents and auditor independence : evidence from audit firm mergers in China

Abstract: 2008 American Accounting Association Annual Meeting in Anaheim, the 2009 Contemporary Accounting Research/Journal of Contemporary Accounting and Economics Special Joint Symposium, and workshops at the Chinese University of Hong Kong and Shanghai University of Finance and Economics for their helpful comments

Equity Incentives and Long‐Term Value Created by SG&A Expenditure*

Abstract: In this paper we investigate how incentives affect managers’ input resource expenditure decisions and how firms make equity grant decisions considering managerial behavior. Focusing on selling, general and administrative (SG&A) expenditure, we first document that SG&A expenditure creates future value that varies across firms and industries. We hypothesize and find that new equity incentives lead to an increase in SG&A expenditure in companies where SG&A creates a high future value. The extent to which long-term incentives impact managers’ expenditure decisions depends on the future value it creates. We also find that firms with high level of SG&A spending grant more new equity incentives when SG&A creates more future value. The evidence is consistent both with managers making rational investment decisions in response to new equity incentives and with firms making efficient grant decisions based on managers’ expected behavior. Overall, this study documents the importance of considering the future value created by input resource expenditure in examining the association between equity incentives and managerial spending behavior.

Is Environmental Performance a Determinant of Bond Pricing? Evidence from the U.S. Pulp and Paper and Chemical Industries*

Abstract: In this study I provide evidence that there is an economically significant relation between a firm’s environmental performance and its bond yields. Firms that have poor environmental performance will face future environmental liabilities related to compliance and clean-up costs due to increasingly strict environmental laws and regulations. These liabilities are large enough to drive polluting firms into bankruptcy and can leave bondholders’ claims subordinate to environmental liabilities. I also find evidence that the relation between environmental performance and bond yields fades as bond quality increases, which is consistent with the non-linear pay-off structure of bonds. This study focuses on two of the most polluting industries in the U.S., chemical and pulp and paper. The paper’s findings support ongoing calls for greater cooperation between the Securities and Exchange Commission (SEC) and the U.S. Environmental Protection Agency (EPA), which would allow for the reporting of quantifiable environmental information in firms’ disclosures. It also provides evidence of environmental performance as a determinant of bankruptcy risk. Bankruptcy due to a history of poor environmental performance often leaves the related environmental liabilities underfunded. Many regulators are required to ensure adequate funds are available for remediation to match ongoing environmental degradation. Thus, the interplay between a firm’s bankruptcy risk and its environmental performance has broad implications.

The Effect of Litigation Risk on Management Earnings Forecasts

Abstract: We examine the effect of litigation risk on managers' decision to issue earnings forecasts. We use a new ex ante measure of litigation risk, namely, the Directors and Officers liability insurance premium. This choice bypasses significant problems associated with the estimation of ex ante litigation risk in prior studies. By using this measure of litigation risk, our results are more intuitively appealing. We find that when faced with ex ante litigation risk, managers with bad news are more likely to issue an earnings warning. For good news firms, we do not see this effect. We also examine three forecast characteristics: forecast horizon, extent of news revealed and forecast precision. Firms with higher litigation risk tend to issue earnings forecasts earlier if they have bad news but not so when they have good news. They also reveal less news in the forecasts if they have good news. As litigation risk increases, bad news earnings forecasts become more precise. Good news earnings forecasts, however, tend to become less precise relative to bad news forecasts. This differential effect of litigation risk on management earnings forecasts, based on the direction of news, has not been documented by previous studies.

The Relative Importance of Firm Incentives versus Country Factors in the Demand for Assurance Services by Private Entities

Abstract: Agency theory views the firm as a nexus of contracts in which information asymmetry exists and creates a conflict of interest between contracting parties (Alchian and Demsetz 1972; Jensen and Meckling 1976). In the limit, contracting will not occur if information asymmetry is not sufficiently resolved, and in this scenario agency problems can be mitigated and contracting facilitated by governance mechanisms like accounting and auditing. Specifically, accounting reports increase a firm’s transparency, and audits can be used for ex post monitoring and enforcement of contracts (Watts and Zimmerman 1983). While important, the seminal agency research does not recognize that the contracting environment varies across countries, which in turn will influence the nature of contracts in place and the related demand for governance mechanisms (La Porta, Lopez-de-Silanes, Shleifer, and Vishny 2000). Agency theory was formulated in the context of modern U.S. corporate ownership in which there is widespread separation of ownership and control and a diversified ownership structure with limited ownership concentration by individuals. The seminal agency literature assumes that the United States has a strong legal system and

Direct and Indirect Effects of Internal Control Weaknesses on Accrual Quality: Evidence from a Unique Canadian Regulatory Setting*

Abstract: In this study we examine the effectiveness of a unique Canadian disclosure approach regarding the adequacy of a firm’s internal control over financial reporting (ICOFR). According to this approach, the disclosures of internal control design weaknesses are contained in the ‘‘Management Discussion and Analysis’’ (MDA Kinney and Shepardson 2010). Since 2007, even nonaccelerated filers have had to report under SOX 404 Part (a) which requires separate management certification of the results of an assessment of internal control design and implementation effectiveness. Further, it appears that

Dividing the Pie: The Influence of Managerial Discretion Extent on Bonus Pool Allocation*

Abstract: An essential role of management is organizational control, or the process of ‘‘ensuring that the organization operates in the intended manner and achieves its goals’’ (Hilton 2008: 6). Accountants support managers in this role by providing information that forms the basis of performance evaluation and incentive-based contracting. However, managers also have available to them other relevant employee performance information — that is, information not explicitly contracted on because it represents unforeseen circumstances, cannot be jointly verified or requires interpretation or judgment. To incorporate this noncontractible information into compensation decisions, firms often allow managers discretion in determining subordinates’ compensation. Specifically, many firms use discretionary bonus pools as the mechanism via which managers apply discretion in compensation. Whereas the size of a bonus pool (in dollars) is typically based on some predetermined formula, firms vary greatly in the extent to which managers are endowed discretion to allocate that pool (Murphy and Oyer 2003). That is, some plans allow managers full discretion in allocating the bonus pool, whereas other plans allow discretion over only a portion of the total pool, with the remainder contractually allocated by formula. In this paper, we investigate the effect of this important institutional factor — discretion extent — on managers’ discretionary bonus allocations. To examine the effect of discretion extent, we develop theory on the processes by which managers will allocate discretionary bonus pools. Analytic research (e.g., Rajan and Reichelstein 2006) models each bonus pool participant’s allocation as a linear combination of performance measures. This linear combination may be conceptualized as a single, comprehensive measure of performance, in which all relevant (contractible and noncontractible) information is integrated. Based on this conceptualization, one might assume that in

The Role of IRS Monitoring in Equity Pricing in Public Firms

Abstract: We analyze the importance of Internal Revenue Service (IRS) monitoring to equity pricing in U.S. public firms. Our strong, robust evidence from large samples implies that equity financing is cheaper when the threat of an IRS audit is higher, enabling investors to learn more about the firm. Reflecting its first-order economic impact, our coefficient estimates translate into the cost of equity capital falling, on average, by 58 basis points when the expected probability of an IRS audit rises from 30.51 percent (the 25th percentile in our data) to 45.86 percent (the 75th percentile). In evidence supporting our second prediction, we find that the link between IRS oversight and equity pricing is stronger in firms with relatively poor corporate governance that experience worse agency problems. Consistent with recent theory on the corporate governance role that tax enforcement plays, our research suggests that a spillover benefit accompanying strict IRS monitoring is lower information asymmetry evident in equity financing costs.

Corporate Frugality: Theory, Measurement and Practice

Abstract: This paper uses a mix of field research and survey methods to provide evidence on the existence of ‘frugality’ as a company characteristic. Drawing upon established scales of frugality in the literature on consumer psychology, we develop and validate a multi-item measure of corporate frugality. A key part of scale development is establishing discriminant validity, the uniqueness from and relatedness to extant constructs. We demonstrate that frugality differs from budgetary control, and is not associated with organizational culture types in the Competing Values framework (Quinn and Rohrbaugh, 1981). Further, we investigate the association between frugality and business strategy using Porter’s (1980) typology of low cost and product differentiation strategies and find that frugality is equally present in companies with both strategies. Having established frugality as a distinct construct, we examine its nomological validity, the consequences of frugality for cost management practice. We find that frugal companies control cost differently and make greater use of a broad range of cost management practices. In sum, we develop and validate a theory-consistent measure of corporate frugality; a construct that has been present in descriptions and anecdotes of business practices of cost management for decades, but which has gained new currency in modern economic times.