Showing papers in "Contemporary Accounting Research in 2014"

The Reputational Costs of Tax Avoidance

Abstract: We investigate whether firms and their top executives bear reputational costs from engaging in aggressive tax avoidance activities. Prior literature has posited that reputational costs partially explain why so many firms apparently forgo the benefits of tax avoidance, the so-called “under-sheltering puzzle.” We employ a database of 118 firms that were subject to public scrutiny for having engaged in tax shelters, representing the largest sample of publicly identified corporate tax shelters analyzed to date. We examine the reputational costs that prior research has shown that firms and managers face in cases of alleged misconduct: increased CEO and CFO turnover, auditor turnover, lost sales, increased advertising costs, and decreased media reputation. Across a battery of tests, we find little evidence that firms or their top executives bear significant reputational costs as a result of being accused of engaging in tax shelter activities. Moreover, we find no decrease in firms’ tax avoidance activities after being accused of tax shelter activity. Finally, in tests of the capital market reaction to news of tax shelter involvement, we find that negative event-period returns fully reverse within a few weeks of the public scrutiny, consistent with a temporary market penalty to tax shelter news. In all, we conclude that there is little evidence of tax shelter usage leading to reputational costs at the firm level.

Financial reporting opacity and expected crash risk: Evidence from implied volatility smirks

Abstract: The recent financial crisis has stimulated a renewed interest in understanding the determinants of stock price crash risk (i.e., left tail risk). Recent research shows that opaque financial reports enable managers to hide and accumulate bad news for extended periods. When the accumulated bad news reaches a certain tipping point, it will be suddenly released to the market at once, resulting in an abrupt decline in stock price (i.e., a crash). This study extends this line of research by examining the impact of financial reporting opacity on perceived or expected crash risk. Prominent economists, such as Olivier Blanchard, argue that removing the perception of tail risks (in addition to realized tail risks) is crucial in restoring investor confidence and stabilizing the stock market. Using the steepness of option implied volatility skew as a proxy for perceived crash risk, we find that accrual management, the presence of financial statement restatements, and auditor-attested internal control weakness are all positively and significantly associated with the level of perceived crash risk. Our results suggest that improving financial reporting transparency is an important mechanism for firms and policymakers to reduce the perception of tail risks and stabilize the stock market.

Being a Successful Professional: : An Exploration of Who Makes Partner in the Big 4

Abstract: Accepted by Yves Gendron. We would like to thank seminar participants at both the United Arab Emirates University and Newcastle University for comments on previous versions of this paper. Additionally, Michel Magnan and Glenn Rioulx were both particularly helpful in facilitating interviews for the Canadian branch of the study, as well as in offering general advice at the outset. The financial support of the Social Sciences and Humanities Research Council of Canada is also warmly acknowledged. The detailed comments offered on each of the paper's various iterations by Yves Gendron and two anonymous reviewers are greatly appreciated. Any remaining errors are our own.

Auditor-in-Charge Characteristics and Going-concern Reporting†

Abstract: We examine the effect of auditor-in-charge characteristics on audit quality using the propensity to issue a going-concern opinion as the measure of audit quality. We extend the sparse literature on ...

Financial Reporting Quality and Labor Investment Efficiency

Abstract: AAA 2011 Western Region Meeting (American Accounting Association), California, USA, 28 - 30 April 2011

CEO after-tax compensation incentives and corporate tax avoidance

Abstract: I examine the association between CEOs’ after-tax incentives and their firms’ levels of tax avoidance. Economic theory holds that firms should compensate CEOs on an after-tax basis when the expected tax savings generated from additional incentive alignment outweigh the incremental compensation demanded by CEOs for bearing additional tax-related compensation risk. Using publicly available data, I estimate CEOs’ after-tax incentives and find a negative relation between the use of after-tax incentives and effective tax rates. While the results suggest that greater use of after-tax measures in CEO compensation leads to higher tax savings, it is possible that these savings will lead to lower pre-tax returns, or implicit taxes. Therefore, I also examine the association between the use of after-tax incentives and implicit taxes and find a positive association between the two. Finally, I find a significant positive relation between after-tax incentives and total CEO compensation, suggesting that CEOs who are compensated after-tax demand a premium for the additional risk they bear.

Does Corporate Tax Aggressiveness Influence Audit Pricing

Abstract: We evaluate whether, and under what circumstances, corporate tax aggressiveness influences audit pricing. Using a compound measure of two long-run effective tax rates, we find that tax aggressive firms pay higher fees for external audit services after controlling for factors related to earnings management. The fee premium increases with management’s uncertainty about the sustainability of tax positions if audited by tax authorities (i.e., disclosed tax reserves). Further, the provision of auditor-provided tax services may create knowledge spillovers that alleviate the fee premium for tax aggressiveness, unless tax uncertainty is high. Finally, an accounting firm’s industry expertise in auditing is associated with higher audit fees independent of tax aggressiveness, whereas industry expertise in taxation leads to a fee premium only for tax aggressive clients. Overall, the evidence implies firms’ aggressive tax behavior, tax services provider, and auditor-expertise interact to influence the pricing of audit engagements.

A Big 4 Firm's Use of Information Technology to Control the Audit Process: How an Audit Support System is Changing Auditor Behavior

Abstract: This study investigates auditors' reactions to a new audit support system that was designed by a Big 4 firm as a response to a stricter regulatory regime. The system's features guide audit teams to comply with the firm's methodology and auditing standards. Understanding auditors' reactions is important because they influence the effectiveness of the system as a control. Our analysis of internal documents from the firm and interviews we conducted with auditors identifies that, although many of the system's features could have been used as a coercive control, this was not the case. The auditors viewed the system positively and reported that it enables the effective delivery of audit engagements. Two primary factors explain their reaction: (1) management's interventions during system deployment, and (2) how the system's design ensures compliance by providing audit teams with constrained choices in applying the system's recommendations. These factors developed an auditor's sense of empowerment by leveraging their skills and knowledge. Empowerment became stronger following management interventions that encouraged audit teams to challenge the system's recommendations. We compare how auditors reacted to the new system with prior research, and document how this system's features are changing auditor behavior and increasing the frequency and timeliness of audit team interaction. This analysis demonstrates that, when used as a process control, an audit support system can have unintended consequences for auditor behavior and interaction. More generally, this study highlights that to understand how technology impacts auditor behavior, it is important to examine the technology's design and deployment. © CAAA.

Future Nonaudit Service Fees and Audit Quality

Abstract: Prior to the Sarbanes�Oxley Act of 2002, audit partners experienced economic pressure to grow revenue from the sale of nonaudit services to their audit clients. To an auditor who is highly rewarded for revenue generation and growth, nonaudit services may represent a particularly strengthened economic bond with the client. Prior research shows that, in general, nonaudit service fees received in the current period do not impair audit quality. We examine a different setting. We propose that auditor independence can become impaired, and audit quality compromised, when clients that currently purchase relatively low amounts of nonaudit services, increase their purchases of nonaudit services from the auditor in the subsequent period. We test our prediction in the context of earnings management as a proxy for audit quality, measured by (a) performance-adjusted discretionary accruals and (b) classification shifting of core expenses. Our results indicate that prior to the Sarbanes-Oxley Act, rewards to the auditor in the form of future additional nonaudit service fees from current-year high fee-growth-opportunity clients adversely affects audit quality. This effect is particularly strong among companies with powerful incentives to manage earnings. Our findings indicate that regulators should consider the multiperiod nature of the client�auditor relationship when contemplating policies that restrict nonaudit services, as well as the overall environment in which audit partners operate. This might include partner compensation arrangements that put pressure on audit partners to focus on increasing revenue at the expense of audit quality.

Auditors’ Professional Skepticism: Neutrality versus Presumptive Doubt†

Abstract: Although skepticism is widely viewed as essential to audit quality, there is a debate about what form is optimal. The two prevailing perspectives that have surfaced are �neutrality� and �presumptive doubt.� With neutrality, auditors neither believe nor disbelieve client management. With presumptive doubt, auditors assume some level of dishonesty by management, unless evidence indicates otherwise. The purpose of this study is to examine which of these perspectives is most descriptive of auditors� skeptical judgments and decisions, in higher and lower control environment risk settings. This issue is important, since there is a lack of empirical evidence as to which perspective is optimal in addressing client risks. An experimental study is conducted involving a sample of 96 auditors from one of the Big 4 auditing firms in the Netherlands, with experience ranging from senior to partner. One of the skepticism measures is reflective of neutrality, the Hurtt Professional Skepticism Scale (HPSS), whereas the other reflects presumptive doubt, the inverse of the Rotter Interpersonal Trust Scale (RIT). The findings suggest that the presumptive doubt perspective of professional skepticism is more predictive of auditor skeptical judgments and decisions than neutrality, particularly in higher-risk settings. Since auditing standards prescribe greater skepticism in higher-risk settings, the findings support the appropriateness of a presumptive doubt perspective and have important implications for auditor recruitment and training, guidance in audit tools, and future research.

The Timeliness of the Bond Market Reaction to Bad Earnings News

Abstract: We find that bond price quotes impound bad earnings news on a more timely basis than good earnings news and that the bond market impounds bad news on a more timely basis than the stock market. We also find that the timeliness of the bond market reaction to bad news is concentrated primarily among speculative-grade bonds, consistent with earnings news having a larger effect on bond price quotes when default risk is high. In addition, we find that a portion of the bad news impounded by the bond market reverses following the earnings announcement. Overall, our findings are consistent with bondholders� asymmetric payoff function having important implications for the valuation role of accounting information in the bond market. Specifically, our findings indicate that bond quotes impound bad earnings news much earlier in the pre-earnings announcement period than stock prices. In addition, bondholders appear to overreact to the bad earnings news initially and correct this overreaction subsequent to the earnings announcement.

The Nominating Committee Process: A Qualitative Examination of Board Independence and Formalization

Abstract: The nominating committee (NC) of the board identifies and nominates individuals for board service, thus establishing the board's composition. Despite this important role, relatively little is known about the NC process, including NC members' actions and thought processes. Based on interviews of 20 U.S. public company NC members, including 16 chairs, we focus on two primary questions: (1) what is the extent of influence that the Chief Executive Officer (CEO) has over committee processes, and (2) to what extent are committee processes formalized (i.e., framed and acted upon in a mechanistic way)? We find that there is continuing recognition of CEO influence in the director nomination process, the level of which varies widely by company. Also, there is considerable variability in the formalization of the director nomination process (e.g., some NCs use search firms and a matrix/grid approach to assessing director skill sets across the board, while others do not). Finally, we find that many interviewees have professional or personal ties to the CEO and that nearly all of the NCs focus on �chemistry� and comfort in the director nomination process, where the often-stated goal is to enhance the board's ability to function effectively and to reduce risk in the director nomination process. The overall message of the interviews perhaps is best captured by one interviewee, who described a �strange little dance.� Throughout the interviews, we find evidence that the NC must �dance� through a complex decision landscape.

Separating the Political and Technical: Accounting Standard-Setting and Purification†

Abstract: The U.S.-based Financial Accounting Standards Board (FASB) emphasizes that accounting standard-setting is not and should not be regarded as a �political process.� Employing the case of accounting for stock compensation, I examine a recent debate in which FASB appears to have successfully established and maintained a boundary between a technical accounting process and politics. This case is interesting because an earlier, failed effort to expense stock compensation was described as highly politicized. However, the boundary between technical and political processes was maintained in the more recent episode. I find that a focus on due process, characterizations of existing accounting requirements as anomalous and available measurement methods as reliable, and warnings about the dangers of injecting �politics� into standard-setting were important to this boundary work. I also find that the boundary work required considerable interpretive flexibility in selecting (or ignoring) the evidence to be used in justifying the standard-setting project and its conclusions. I conclude by suggesting that a different understanding of what it means to be involved in a �political process� might help all parties understand more fully what is taking place during the accounting standard-setting process. Attention could be turned to developing processes to facilitate debates over which values should guide decisions occurring throughout the standard-setting process. To this end, an enhanced standard-setting process might allow for increased participation in agenda setting, in framing and scoping standard-setting projects, and in providing opportunities for nonexperts to participate.

Optimistic Reporting and Pessimistic Investing: Do Pro Forma Earnings Disclosures Attract Short Sellers?

Abstract: We contribute to the debate regarding the informativeness of pro forma earnings disclosures by providing evidence that a group of informed traders, short sellers, trade as if firms’ voluntary non-GAAP earnings disclosures create information advantages they can exploit. While prior research indicates that short sellers identify firms that will experience declining operating performance, we investigate whether the disclosure of pro forma earnings acts as an indicator of future price declines that is distinct from poor operating performance. We find that short selling is significantly higher in quarters in which firms disclose non-GAAP earnings metrics relative to quarters in which they do not disclose adjusted earnings measures. Moreover, we find that short selling is significantly positively associated with the exclusion of recurring items and, more particularly, with the exclusion of stock-based compensation. We also find some evidence that short sellers trade more when managers exclude expense items to appear to meet analysts’ expectations on a pro forma basis when they fall short of expectations based on GAAP operating earnings. Finally, we find evidence based on abnormal returns suggesting that short sellers profit from short selling around earnings announcements containing pro forma earnings disclosures. Overall, the results are consistent with the notion that sophisticated market participants view pro forma earnings disclosures negatively and trade in order to take advantage of potential information asymmetries created by these disclosures.

Operating Leases and Credit Assessments

Abstract: Operating leases have grown significantly as a source of corporate financing over the last 30 years. Their off-balance sheet treatment, which may in part explain their popularity, raises concern that financial risk may be misjudged and capital misallocated. Prior research evidence on the above issue is mixed. To improve reporting transparency, regulators propose a new accounting concept, right of use, which will add the present value of most leases to the balance sheet. We examine the effect of operating leases on loan pricing by banks, a sophisticated financial statement user. Since leases are a potential debt substitute, we expect them to be important in our setting. With loan spreads as the dependent variable, we test the differential explanatory power and model fit of as-reported financial ratios versus financial ratios adjusted for the capitalization of operating leases. We find that lease-adjusted financial ratios better explain loan spreads, especially for larger lenders. Our results also suggest that retailer leases that are closer in substance to rental agreements than financed asset purchases are less relevant for credit risk assessments. Thus we conclude that banks not only price operating leases, on average, but also make distinctions about which leases should be priced. Second, we explore the role of credit rating agencies and confirm that credit ratings also reflect capitalized operating leases, and find support for an informational role for others’ credit assessments. However, unlike banks, rating agencies appear to capitalize all operating leases mechanically. Overall, our results suggest that banks and rating agencies adjust for the off-balance sheet presentation of operating leases and, at least in the case of banks, attempt to do so to reflect the underlying economics of the leases. This evidence lessens concern over the potential negative consequences of existing operating lease accounting and raises concern over proposed accounting that capitalizes all leases regardless of their economic characteristics.

Analysts' Cash Flow Forecasts and the Decline of the Accruals Anomaly

Abstract: The accruals anomaly, demonstrated by Sloan (1996), generated significant excess returns consistently for over four decades until 2002, but has apparently weakened in the subsequent period. In this paper, I argue that one factor responsible for this decline is the increasing incidence of analysts’ cash flow forecasts that provides markets with forecasts of future accruals. The negative relationship between accruals and future returns is significantly weaker in the presence of cash flow forecasts. This anomalous relationship becomes weaker with the initiation cash flow forecasts but continues after cash flow forecasts are terminated. Further, the mitigating effect of cash flow forecasts is greater for forecasts that are more accurate. The results are incremental to explanations based on the improved accrual quality, reduced manipulation of special items and restructuring charges and greater investment in accruals strategies by hedge funds and highlight the increasing importance of analysts’ cash flow forecasts in the appropriate valuation of stocks.

Chief Financial Officers as Inside Directors

Abstract: Considerable prior research investigates whether the extent of insider presence on corporate boards is detrimental. However, the majority of past research treats all inside directors as a homogenous group. This study considers that issue in the context of chief financial officers (CFO) serving on their own company's board. Our research is important because individuals in different executive roles bring different skills and knowledge to board interactions, highlighting the potential for differential contributions. As prior research does not specifically distinguish CFOs from other board insiders, the potential benefits of knowledge sharing due to increased communication with other board members may have been masked. Specifically, the CFO is directly responsible for the quality of the financial reporting process and can therefore be associated with specific outcome measures. Our results show that the percentage of CFOs serving on their own boards is not large, likely due to the perspective (consistent with agency theory and reflected in independence guidelines) that company insiders on boards could promote their own best interest at the expense of shareholders. Contrary to this perception, we find that companies whose CFO has a seat on the board are associated with higher financial reporting quality (i.e., a lower likelihood of reporting a material weaknesses in internal controls or having a financial restatement, and better accruals quality). Yet, we also find potential drawbacks in that CFOs with a board seat tend to have higher excess compensation and lower likelihood of termination following poor performance, signaling greater entrenchment. While our results provide information to companies considering appointing the CFO to the board, both costs and benefits are demonstrated, and thus we conclude that each board should consider this decision based on its own circumstances and composition.

Implications of insufficient and excess cash for future performance

Abstract: This paper investigates whether future performance suffers when a firm deviates from an estimated optimal cash level Results show that one year ahead RNOA and stock returns are decreasing in the level of deviation from an estimated optimal for both firms holding insufficient cash and firms holding excess cash Investment strategies based on estimated insufficient and excess cash produce positive abnormal returns Integrating our insufficient/excess cash strategies with an accruals-based strategy indicates that these strategies are complimentary for firms with insufficient cash but not for firms with high excess cash; the accruals anomaly does not hold for firms with high excess cash

Equity Incentives and Internal Control Weaknesses

Abstract: In this study, we examine whether the monetary incentives associated with equity ownership (broadly defined to include stock and stock options) induce managers to maintain strong internal controls. Supporting the notion that equity ownership provides management incentive to strengthen the company's internal controls we find that the likelihood of a material weakness in internal control decreases with increases in equity incentives. This result holds for both traditional regression analysis, as well as analysis conducted using propensity score matching. Further analysis suggests that these results are more closely related to company-level internal control problems, are more strongly associated with incentives provided by restricted equity, and are more highly correlated with CFO than CEO incentives.

Debt Financing and Accounting Conservatism in Private Firms

Abstract: This study investigates the role of public debt financing in shaping accounting conservatism in privately held companies. We focus on the change in conservatism of private firms following initial issuance of public debt and examine the effects of agency conflicts between bondholders and shareholders on the change in conservatism. Regression analyses on a large sample of public bond issues by Korean private firms reveal the following. First, private firms with public debt exhibit a higher degree of conservatism than those with exclusively private debt. The incremental effect of public debt on the level of conservatism is virtually equivalent in magnitude to that of public equity. Second, and more importantly, private firms that issue public debt for the first time show a significant increase in conservatism, whereas corresponding public firms do not. Third, private firms with high agency costs of public debt (characterized by high information asymmetry and high credit risk) undergo a greater increase in conservatism following their initial bond issues than those with low agency costs. Further analysis shows that private firms sustain increased levels of conservatism even beyond the time period of average maturity of initial bonds, and that bond investors reward this long-term commitment to conservative accounting by gradually reducing interest rates for seasoned bond issuers. The findings of this study shed light on how information demand arising from public debt issuance, especially by private firms with high ex ante agency costs, engenders conservative financial reporting in emerging markets.

The predictive ability of fair values for future financial performance of commercial banks and the relation of predictive ability to banks' share prices

Abstract: For a sample of commercial banks during 1994 – 2008, we find that accumulated fair value adjustments for interest-bearing investment securities are positively associated with future interest income and total realized income from these investments. Additional tests reveal that accumulated fair value adjustments on investment securities also have predictive ability for future investment-security-related cash flows. Our analyses reveal that our predictive ability proxy for interest-bearing investment securities is positively related to the measurement precision of reported fair value measurements. We also provide evidence that the relative ability of fair values to predict reported accounting income is a factor that strengthens the association between fair values and commercial banks’ stock prices. Taken together, our study suggests that fair values have predictive ability for future income realization despite the low persistence of changes in fair value that has been extensively documented in prior studies. Further, we find that our proxy for predictive ability captures banks’ expectations of future above- or below-market relative interest income, which is a real economic condition that is incrementally reflected in current equity prices.

Information acquisition and opportunistic behavior in managerial reporting

Abstract: Prior experimental studies have investigated factors affecting the honesty of managerial reporting in contexts where managers have no discretion in determining what information to acquire before making their reports In many organizations, however, responsibility for acquiring information is delegated to local managers Such delegated decision rights give managers discretion regarding what information to supply to the accounting system on which their reports are based We predict that discretion may promote opportunistic reporting behavior because it allows managers to avoid relevant information and, in turn, report so as to maximize personal wealth without being knowingly untruthful We investigate this prediction via two experiments Results of Experiment 1 suggest that whether discretion in information acquisition affects reporting behavior is influenced by an individual’s preference for honesty (ie, ethical type) We conduct Experiment 2 to investigate whether this is the case Results show that, although discretion does not affect the reporting behavior of participants with low or high honesty preferences, participants with moderate honesty preferences tend to exploit discretion in order to avoid relevant information and report opportunistically Our results suggest that the ability to exploit opportunities afforded by discretion in information acquisition is a potential cost when weighing the costs and benefits of assigning decision rights to managers Our results also highlight the importance of considering a manager’s ethical type when assigning decision rights

CEO Pay‐for‐Complexity and the Risk of Managerial Diversion from Multinational Diversification

Abstract: Prior studies find that CEOs receive higher pay if the enterprise is more complex because more complex enterprises are, in theory, matched with the managerial skills of higher-ability CEOs. While multinational diversification is typically a characteristic of enterprise complexity, we argue that multinational diversification also introduces a risk that executives will divert an enterprise’s resources to obtain private benefits. We first establish that CEO pay is, on average, increasing in the extent of multinational diversification, consistent with intuition that more complex enterprises are matched to higher‐ability CEOs. We then demonstrate that the CEO pay‐for‐complexity premium is lower if the multinational diversification reflects a relatively high risk of managerial diversion. For sufficiently high levels of multinational diversification accompanied by a high risk of managerial diversion, we find that CEOs receive a relative reduction in pay rather than a pay premium for multinational diversification. We also find evidence that this pay effect occurs in part through adjustments to a CEO’s pay‐for‐performance sensitivity.

Forecasting Sales: A Model and Some Evidence from the Retail Industry*

Abstract: This paper presents a sales forecasting model and tests the model on a sample of firms in the retail industry. The model distinguishes between sales growth due to an increase in the number of sales-generating units (e.g. opening new stores) and growth due to an increase in the sales rate at the existing units (e.g. the comparable store growth rate). The model accommodates different trends in the sales rates, allowing new stores to earn more or less than existing stores, perhaps because new stores are different sizes than existing stores or may take either a long time to reach maturity or alternatively enjoy an early “fad” status. We show how to use the historical series of sales, stores and comparable store growth rates to estimate the sales rates on new stores and on existing stores. The model uses only a few years of firm-specific, publicly available information, yet generates in-sample forecast errors of less than two percent of sales, generates out-of-sample forecast errors that are comparable to analyst revenue forecasts, and when used with analyst forecasts, adds significant incremental information.

The Effects of Presentation Salience and Measurement Subjectivity on Nonprofessional Investors' Fair Value Judgments

Abstract: Fair value estimates reported in the financial statements differ in the subjectivity with which the estimates are measured. Mandated supplemental disclosures are intended to enable users to assess the nature of the inputs used to develop the fair value measurements, including their relative reliability, although prior research suggests some investors may have difficulty doing so. We draw on information processing research to predict and find that isolating fair value information in a separate column on the face of the income statement facilitates nonprofessional investors’ ability to incorporate into their perceived reliability and P/E judgments not only the fair value estimates, but also the disclosed measurement differences that underlie those estimates. Our results have implications for standard setters and researchers concerned with the effects of financial statement presentation on nonprofessional investors. Namely, we demonstrate how income statement presentation can improve reliance on mandated supplemental disclosures, thereby resulting in greater financial statement transparency.

Timeliness of Analysts' Forecasts: The Information Content of Delayed Forecasts

Abstract: The average number of security analysts following a firm has increased dramatically over the last decade. Prior research has documented that information asymmetry between managers and investors is negatively associated with the number of analysts following a firm (for example, Brennan and Subrahmanyam, 1995, and Easley, O'Hara, and Paperman, 1998). When a large number of analysts release forecasts for a single firm, the question arises as to what is the marginal informativeness of the forecast released by the nth follower analyst? In this paper, we classify analysts as leaders and followers based on the relative timeliness of their earnings forecasts. We then compare leaders and followers among analysts on various performance attributes linked to analyst compensation, such as price impact, accuracy, boldness, and dimensionality. The objective of this analysis is to shed some light on what role leaders and followers among analysts play in the capital market.