Showing papers in "Journal of Accounting Research in 2008"

Mandatory IFRS Reporting around the World: Early Evidence on the Economic Consequences

Abstract: This paper examines the economic consequences of mandatory International Financial Reporting Standards (IFRS) reporting around the world. We analyze the effects on market liquidity, cost of capital, and Tobin's q in 26 countries using a large sample of firms that are mandated to adopt IFRS. We find that, on average, market liquidity increases around the time of the introduction of IFRS. We also document a decrease in firms' cost of capital and an increase in equity valuations, but only if we account for the possibility that the effects occur prior to the official adoption date. Partitioning our sample, we find that the capital-market benefits occur only in countries where firms have incentives to be transparent and where legal enforcement is strong, underscoring the central importance of firms' reporting incentives and countries' enforcement regimes for the quality of financial reporting. Comparing mandatory and voluntary adopters, we find that the capital market effects are most pronounced for firms that voluntarily switch to IFRS, both in the year when they switch and again later, when IFRS become mandatory. While the former result is likely due to self-selection, the latter result cautions us to attribute the capital-market effects for mandatory adopters solely or even primarily to the IFRS mandate. Many adopting countries make concurrent efforts to improve enforcement and governance regimes, which likely play into our findings. Consistent with this interpretation, the estimated liquidity improvements are smaller in magnitude when we analyze them on a monthly basis, which is more likely to isolate IFRS reporting effects.

International Accounting Standards and Accounting Quality

Abstract: We examine whether application of International Accounting Standards (IAS) is associated with higher accounting quality. The application of IAS reflects combined effects of features of the financial reporting system, including standards, their interpretation, enforcement, and litigation. We find that firms applying IAS from 21 countries generally evidence less earnings management, more timely loss recognition, and more value relevance of accounting amounts than do matched sample firms applying non-U.S. domestic standards. Differences in accounting quality between the two groups of firms in the period before the IAS firms adopt IAS do not account for the postadoption differences. Firms applying IAS generally evidence an improvement in accounting quality between the pre- and postadoption periods. Although we cannot be sure our findings are attributable to the change in the financial reporting system rather than to changes in firms' incentives and the economic environment, we include research design features to mitigate effects of both.

Voluntary Disclosure, Earnings Quality, and Cost of Capital

Abstract: We investigate the relations among voluntary disclosure, earnings quality, and cost of capital. We find that firms with good earnings quality have more expansive voluntary disclosures (as proxied by a self-constructed index of coded items found in 677 firms' annual reports and 10-K filings in fiscal 2001) than firms with poor earnings quality. In unconditional tests, we find that more voluntary disclosure is associated with a lower cost of capital. However, consistent with the complementary association between disclosure and earnings quality, we find that the disclosure effect on cost of capital is substantially reduced or disappears completely (depending on the cost of capital proxy) once we condition on earnings quality. Extensions probing alternative proxies show that our findings are robust to measures of earnings quality and cost of capital, but not to other measures of voluntary disclosure. In particular, we find opposite relations for voluntary disclosure measures based on management forecasts and conference calls, and we find no relations for a press release based measure. Copyright University of Chicago on behalf of the Institute of Professional Accounting, 2008.

Managerial Ownership and Accounting Conservatism

Abstract: In this paper we examine the effect of managerial ownership on financial reporting conservatism. Separation of ownership and control gives rise to agency problems between managers and shareholders. Financial reporting conservatism is one potential mechanism to address these agency problems. We hypothesize that, as managerial ownership declines, the severity of agency problem increases, increasing the demand for conservatism. Consistent with our hypothesis, we find that conservatism as measured by the asymmetric timeliness of earnings declines with managerial ownership. The negative association between managerial ownership and asymmetric timeliness of earnings is robust to various controls, in particular, for the investment opportunity set. We thus provide evidence of a demand for conservatism from the firm's shareholders.

Managerial Empire Building and Firm Disclosure

Abstract: This study tests the agency cost hypothesis in the context of geographic earnings disclosures. The agency cost hypothesis predicts that managers, when not monitored by shareholders, make self-maximizing decisions that may not necessarily be in the best interest of shareholders. These decisions include aggressively growing the firm, which reduces profitability and destroys firm value. Geographic earnings disclosures provide an interesting context to examine this issue. Beginning with Statement of Financial Accounting Standards No. 131 (SFAS 131), most U.S. multinational firms are no longer required to disclose earnings by geographic area (e.g., net income in Mexico or net income in East Asia). Such nondisclosure potentially reduces the ability of shareholders to monitor managers' decisions related to foreign operations. Using a sample of U.S. multinationals with substantial foreign operations, we find that nondisclosing firms, relative to firms that continue to disclose geographic earnings, experience greater expansion of foreign sales, produce lower foreign profit margins, and have lower firm value in the post–SFAS 131 period. Our conclusions are strengthened by the fact that these differences do not exist in the pre–SFAS 131 period and do not relate to domestic operations. We find differences in the predicted direction only for foreign operations and only after adoption of SFAS 131. Our results are robust to the inclusion of an extensive set of control variables related to alternative corporate governance mechanisms, operating performance, and the firm's information environment. Overall, the results are consistent with the agency cost hypothesis and the important role of financial disclosures in monitoring managers.

Do Family Firms Provide More or Less Voluntary Disclosure

Abstract: We examine the voluntary disclosure practices of family firms. We find that, compared to nonfamily firms, family firms provide fewer earnings forecasts and conference calls, but more earnings warnings. Whereas the former is consistent with family owners having a longer investment horizon, better monitoring of management, and lower information asymmetry between owners and managers, the higher likelihood of earnings warnings is consistent with family owners having greater litigation and reputation cost concerns. We also document that family ownership dominates nonfamily insider ownership and concentrated institutional ownership in explaining the likelihood of voluntary disclosure. Using alternative proxies for the founding family's presence in the firm leads to similar results.

Marking-to-Market: Panacea or Pandora's Box?

Abstract: Financial institutions have been at the forefront of the debate on the controversial shift in international standards from historical cost accounting to mark-to-market accounting. We show that the trade—offs at stake in this debate are far from one-sided. While the historical cost regime leads to some inefficiencies, marking to market may lead to other types of inefficiencies by injecting artificial risk that degrades the information value of prices, and induces sub—optimal real decisions. We construct a framework that can weigh the pros and cons. We find that the damage done by marking to market is greatest when claims are (i) long—lived, (ii) illiquid, and (iii) senior. These are precisely the attributes of the key balance sheet items of banks and insurance companies. Our results therefore shed light on why banks and insurance companies have been the most vocal opponents of the shift to marking to market.

Corporate governance and agency conflicts

Abstract: I investigate whether corporate governance is associated with the level of agency conflicts in firms. I employ exploratory principal components analysis on 22 individual governance variables to obtain seven factors that represent the different dimensions of governance for a firm. I measure the level of agency conflicts in firms based on seven proxies for agency conflicts used in the literature. I find that firms with greater agency conflicts have better governance mechanisms in place, particularly those related to the board, audit committee, and auditor. I also find that the composition and functioning of the board, the independence of the auditor, and the equity-based compensation of directors are significantly associated with firm performance, but primarily for firms with high agency conflicts. Overall, the results support the theory that the existence and role of various governance mechanisms in a firm are a function of the level of agency conflicts in the firm. Copyright (c), University of Chicago on behalf of the Institute of Professional Accounting, 2008.

Evidence of Management Discrimination Among Analysts during Earnings Conference Calls

Abstract: This paper considers the potential for public information disclosures to complement the existing private information of financial analysts. In such a setting, analysts allowed to participate during earnings conference calls by asking questions receive public signals that can facilitate the generation of new and valuable private information for the asking analyst. Realizing these public signals are valuable for the asking analyst, managers can use their discretion to discriminate among analysts by granting more participation to more favorable analysts. I use post–Regulation Fair Disclosure conference call transcripts to document that the probability of an analyst asking a question during an earnings conference call is increasing in the favorableness of the analyst's outstanding stock recommendation. I also find that downgrades are associated with decreases in access to management during the conference call relative to other recommendation change activity. Analyst prestige moderates these effects. Favorable and prestigious analysts have higher participation probabilities than favorable and unprestigious analysts. Further, downgrades result in participation decreases only for unprestigious analysts. These findings are consistent with practitioner and regulatory concerns that managers discriminate among analysts by allowing more management access to more favorable analysts.

Non-audit Service Fees and Audit Quality: The Impact of Auditor Specialization

Abstract: We posit that the effect of non-audit fees on audit quality is conditional on auditor industry specialization. Industry specialist auditors are more likely than nonspecialists to be concerned about reputation losses and litigation exposure, and to benefit from knowledge spillovers from the provision of non-audit services. We find evidence that audit quality measured by increased propensity to issue going-concern opinion, increased propensity to miss analysts' forecasts, as well as higher earnings-response coefficients increases with the level of non-audit services acquired from industry specialist auditors compared to nonspecialist auditors.

The Debt‐Contracting Value of Accounting Information and Loan Syndicate Structure

Abstract: We investigate how both the ownership structure and explicit contractual structure of syndicated loan deals are shaped by the debt-contracting value (DCV) of borrowers' accounting information. DCV captures the inherent ability of firms' accounting numbers to capture credit quality deterioration in a timely fashion. We hypothesize and document that when a borrower's accounting information possesses higher DCV, information asymmetry between the lead arranger and other syndicate participants is lower, allowing lead arrangers to hold a smaller proportion of new loan deals. Further, we document that the influence of DCV on the proportion of the loan retained is conditional on the lead arranger's reputation, the existence of a credit rating, and the lead arranger's previous relationships with the same borrower. Finally, we find that when loans include performance pricing provisions, the likelihood that the single performance measure used is an accounting ratio, rather than a credit rating, is increasing in DCV.

Does Auditor Reputation Matter? The Case of KPMG Germany and ComROAD AG

Abstract: We study the stock and audit market effects associated with a widely publicized accounting scandal involving a public company (ComROAD AG) and a large, reputable audit firm (KPMG) in a country (Germany) that has long provided auditors with substantial protection from shareholder legal liability. We use this event to study whether an auditor's reputation helps to ensure audit quality, a rationale for which recent literature and events provide scant support. Given the absence of a strong insurance rationale for audit quality, Germany permits a relatively clean test of whether auditor reputation matters. We find that KPMG's clients sustain negative abnormal returns of 3% at events pertaining to ComROAD, and that these returns are more negative for companies that are likely to have higher demands for audit quality. We also find an increase in the number of clients that drop KPMG in the year of the ComROAD scandal (mostly smaller, recently public companies that are similar to ComROAD). Overall, our results provide support for the reputation rationale for audit quality.

Implications of Transaction Costs for the Post–Earnings Announcement Drift

Abstract: This paper examines the effect of transaction costs on the post–earnings announcement drift (PEAD). Using standard market microstructure features we show that transaction costs constrain the informed trades that are necessary to incorporate earnings information into price. This implies weaker return responses at the time of the earnings announcement and higher subsequent returns drift for firms with higher transaction costs. Consistent with this prediction, we find that earnings response coefficients are lower for firms with higher transaction costs. Using portfolio analyses, we find that the profits of implementing the PEAD trading strategy are significantly reduced by transaction costs. In addition, we show, using a combination of portfolio and regression analyses, that firms with higher transaction costs are the ones that provide the higher abnormal returns for the PEAD strategy. Our results indicate that transaction costs can provide an explanation not only for the persistence but also for the existence of PEAD.

How Much New Information Is There in Earnings

Abstract: We quantify the relative importance of earnings announcements in providing new information to the share market, using the R2 in a regression of securities' calendar-year returns on their four quarterly earnings-announcement “window” returns. The R2, which averages approximately 5% to 9%, measures the proportion of total information incorporated in share prices annually that is associated with earnings announcements. We conclude that the average quarterly announcement is associated with approximately 1% to 2% of total annual information, thus providing a modest but not overwhelming amount of incremental information to the market. The results are consistent with the view that the primary economic role of reported earnings is not to provide timely new information to the share market. By inference, that role lies elsewhere, for example, in settling debt and compensation contracts and in disciplining prior information, including more timely managerial disclosures of information originating in the firm's accounting system. The relative informativeness of earnings announcements is a concave function of size. Increased information during earnings-announcement windows in recent years is due only in part to increased concurrent releases of management forecasts. There is no evidence of abnormal information arrival in the weeks surrounding earnings announcements. Substantial information is released in management forecasts and in analyst forecast revisions prior (but not subsequent) to earnings announcements.

Investor Sentiment and Corporate Disclosure

Abstract: This paper investigates how firms react strategically to investor sentiment via their disclosure policies in an attempt to influence the sentiment-induced biases in expectations. Proxying for sentiment using the Michigan Consumer Confidence Index, we show that during low-sentiment periods, managers increase forecasts to “walk up” current estimates of future earnings over long horizons. In contrast, during periods of high sentiment, managers reduce their long-horizon forecasting activity. Further, while there is an association between sentiment and the biases in analysts' estimates of future earnings, management disclosures vary with sentiment even after controlling for analyst pessimism, indicating that managers attempt to communicate with investors at large, and not just analysts. Our study provides evidence that firms' long-horizon disclosure choices reflect managers' desire to maintain optimistic earnings valuations.

The Persistence and Pricing of the Cash Component of Earnings

Abstract: Prior research shows that the cash component of earnings is more persistent than the accrual component. We decompose the cash component into: (1) the change in the cash balance, (2) issuances/distributions to debt, and (3) issuances/distributions to equity. We find that the higher persistence of the cash component is entirely due to the subcomponent related to equity. The other subcomponents have persistence levels almost identical to accruals. We investigate whether investors understand the implications of the differential persistence of the three subcomponents. Our results suggest that investors correctly price debt and equity issuances/distributions but misprice the change in the cash balance in a similar manner to accruals. Our tests enable us to empirically distinguish the “accrual” and “external financing” anomalies with results implying that the accrual anomaly subsumes the external financing anomaly. Our results also suggest that naive fixation on earnings is unlikely to be a complete explanation for the accrual anomaly. Our findings are more consistent with investors misunderstanding diminishing returns to new investments.

Earnings Volatility, Cash Flow Volatility, and Informed Trading

Abstract: I examine whether earnings that are smoother or more volatile than cash flows provide or garble information. Consistent with theories that predict more informed trading when public information is less informative, I find that bid-ask spreads and the probability of informed trading are higher both when earnings are smoother than cash flows and also when earnings are more volatile than cash flows. Additional tests suggest that managers' discretionary choices that lead to smoother or more volatile earnings than cash flows garble information, on average. However, I find that informed trading is attenuated in settings in which theory suggests that discretionary smoothing or volatizing of earnings is likely to be informative.

Regulation and Bonding: The Sarbanes-Oxley Act and the Flow of International Listings

Abstract: In this paper, we examine the economic impact of the Sarbanes-Oxley Act (SOX) by analyzing foreign listing behavior onto U.S. and U.K. stock exchanges before and after the enactment of SOX in 2002. Using a sample of all listing events onto U.S. and U.K. exchanges from 1995–2006, we develop an exchange choice model that captures firm-level, industry-level, exchange-level, and country-level listing incentives, and test whether these listing preferences changed following the enactment of SOX. After controlling for firm characteristics and other economic determinants of these firms' exchange choice, we find that the listing preferences of large foreign firms choosing between U.S. exchanges and the London Stock Exchange's (LSE) Main Market did not change following the enactment of SOX. In contrast, we find that the likelihood of a U.S. listing among small foreign firms choosing between the NASDAQ and LSE's Alternative Investment Market decreased following the enactment of SOX. The negative effect among small firms is consistent with these marginal companies being less able to absorb the incremental costs associated with SOX compliance. The screening of smaller firms with weaker governance attributes from U.S. exchanges is consistent with the heightened governance costs imposed by SOX increasing the bonding-related benefits of a U.S. listing.

Audit Labor Usage and Fees under Business Risk Auditing

Abstract: The adoption of business risk audit (BRA) approaches during the 1990s by several leading audit firms has been the subject of considerable scrutiny and commentary. Under BRA, the auditor responds to the increasing complexity of auditee financial reports by acquiring a deep and comprehensive understanding of the auditee’s industry, strategy, business models, and processes— tasks best accomplished by higher-ranked labor—and by employing this understanding to make audit labor allocations. Using proprietary data for 165 audits conducted in 2002, we investigate three propositions about audit labor use under BRA. First, relative to pre-BRA benchmarks for the same auditor, we expect BRA audits to use a greater proportion of higher-ranked labor. Second, we expect engagements with high assessed auditor business risk (ABR), a summary risk assessment that reflects the BRA auditor’s rich understanding of the auditee, to be allocated more labor and more higher-ranked labor than pre-BRA benchmarks. Third, at all ranks of labor, we expect a positive association between assessed ABR and levels of labor use. We find empirical evidence consistent with these propositions. We also find that total labor use in our sample is only modestly lower than pre-BRA norms. Analysis of fee data from these engagements suggests that audit fees in 2002 are substantially less than would be expected under pre-BRA benchmarks. After controlling for

Disclosure Quality and Management Trading Incentives

Abstract: This study examines whether managers strategically alter disclosure "quality" in response to personal incentives, specifically those derived from trading on their own account. Using changes in market liquidity to proxy for disclosure quality, I find that trading incentives are associated with disclosure quality choices. Tests are performed across three disclosure samples: management forecasts, conference calls, and press releases. Consistent with a desire to reduce the probability of litigation, I find evidence that managers provide higher quality disclosures before selling shares than they provide in the absence of trading. Consistent with a desire to maintain their information advantage, I find some, albeit weaker, evidence that managers provide lower quality disclosures prior to purchasing shares than they provide in the absence of trading.

Intertemporal Dynamics of Corporate Voluntary Disclosures

Abstract: While empirical evidence alludes to the intertemporal nature of corporate voluntary disclosures, most of the existing theory analyzes firms' voluntary disclosure decisions within single-period settings. Introducing a repeated, multiperiod, disclosure setting, we study the extent to which firms' strategic disclosure behavior in the past affects their prosperity to provide voluntary disclosures in the future. Our analysis demonstrates that by voluntarily disclosing private information firms make an implicit commitment to provide similar disclosures in the future, and therefore are less willing to voluntarily disclose information in the first place. This effect is expected to be of larger magnitude for firms (1) with a long history of absence of voluntary disclosures and an impressive past operating performance, or (2) that operate in a relatively stable and predictable business and information environment, or (3) whose managers have a long time horizon and a high degree of risk aversion.

On the Optimal Relation between the Properties of Managerial and Financial Reporting Systems

Abstract: We develop a theoretical model of the firm that links properties (stewardship vs. valuation focus) of financial reporting regimes with the informational properties of optimal managerial accounting systems. We show that, contrary to the standard textbook proposition, properties of management and financial accounting systems are not independent. Significantly, we provide an explicit connection between exogenous and observable properties of a firm's financial reporting system and the quality of the managerial accounting system on which manager(s) base real economic decisions. As the quality of those economic decisions can also be inferred from publicly available data, our theory generates new opportunities for empirical managerial accounting research on large nonproprietary samples. Further, by being able to identify enhanced performance due to improved managerial accounting information, our theory provides opportunities to gain a better understanding of the link between particular managerial accounting practices and the quality of the information produced.

Nonfinancial Performance Measures and Promotion-Based Incentives

Abstract: In this paper, I examine the sensitivity of promotion and demotion decisions for lower-level managers to financial and nonfinancial measures of their performance and investigate the extent to which the behavior of lower-level managers reflects promotion-based incentives. Additionally, I test for learning versus effort-allocation effects of promotion-based incentives. I find that promotion and demotion decisions for store managers of a major U.S.-based fast-food retailer (QSR) are sensitive to nonfinancial performance measures of service quality and employee retention after controlling for financial performance. The likelihood of demotion in this organization is also sensitive to nonfinancial performance on the dimension of service quality, while the probability of exit is primarily sensitive to financial performance measures rather than nonfinancial performance measures. I also find evidence that the behavior of lower-level managers is consistent with the incentives created by the weighting of nonfinancial performance measures in promotion decisions. Managers in locations where there is a higher ex ante probability of promotion and a higher potential reward upon promotion demonstrate significantly higher levels and rates of performance improvement in service quality. Finally, consistent with promotion-based incentives inducing both effort-allocation and learning effects, I find that performance-improvement rates for service quality: (1) are higher in prepromotion periods in markets where promotions occur, (2) decrease immediately after the occurrence of a promotion in the same market area, and (3) remain higher than in markets where promotions do not occur. These findings provide some of the first empirical evidence on an alternative to the explicit weighting of nonfinancial metrics in compensation contracts as a mechanism for generating improvements in nonfinancial dimensions of performance.

Board Independence and CEO Turnover

Abstract: This paper analyzes how board independence affects the CEO's ability to extract rents from the firm. The CEO is assumed to possess private information about his ability, which the board needs in order to decide whether to replace him. If the board is more active in removing low quality CEOs, the incumbent is better able to use his information advantage to extract rents. Since the board cannot commit not to renegotiate the contract, a board that is fully independent from the CEO is more active than is efficient ex ante. For this reason, shareholders are better off if the board of directors lacks some independence. The model predicts that a trend toward greater board independence is associated with subsequent trends toward higher CEO turnover, more generous severance packages, and larger stock option grants.

Retracted: Relationship Incentives and the Optimistic/Pessimistic Pattern in Analysts' Forecasts

Abstract: We examine whether analysts' incentives to maintain good relationships with management contribute to the optimistic/pessimistic within-period time trend in analysts' forecasts. In our experiments, 81 experienced sell-side analysts from two brokerage firms predict earnings based on historical information and management guidance. Analysts' forecasts exhibit an optimistic/pessimistic pattern across the two timing conditions (early and late in the quarter), and the effect is significantly stronger when the analysts have a good relationship with management than when their only incentive is to be accurate. Debriefing results indicate that analysts are aware of this pattern of forecasts, and believe that this benefits their future relationships with management and with brokerage clients. The analysts most frequently cite favored conference call participation and information access when describing benefits from maintaining good relationships with management. Our results suggest the following: The optimistic/pessimistic pattern in forecasts is in part a conscious response to relationship incentives, information access is perceived to be a major benefit of management relationships, and recent regulatory changes may have lessened but have not eliminated this conflict of interest source.

Client Characteristics and the Negotiation Tactics of Auditors: Implications for Financial Reporting

Abstract: Although the financial statements of an organization are considered a product of management, prior research suggests that a company's financial statements may be affected by the negotiation strategy employed by the auditor when resolving audit differences with management. However, little subsequent research discusses the potential strategies that auditors may employ during the negotiation process. Our study extends the literature by investigating, in a post–Sarbanes-Oxley environment, whether auditors will employ a reciprocity-based strategy for the resolution of audit differences and what client characteristics (client management's negotiating style and client retention risk) increase the extent to which it is utilized. Further, we explore the potential effect of a reciprocity-based strategy on the quality of the financial statements. Such a strategy involves bringing inconsequential items to management and subsequently waiving these items in an effort to encourage management to be more cooperative in the posting of significant income-decreasing adjustments. The results of experiment 1 indicate that client management's negotiating style and retention risk have an interactive effect on auditors' use of a reciprocity-based strategy. Specifically, auditors are more likely to utilize a reciprocity-based strategy when management's negotiating style is competitive and client retention risk is high. Experiment 2 findings suggest that the auditor's use of reciprocity during negotiation can actually result in more conservative financial statements by helping the auditor manage perceived client pressures to waive or reduce proposed adjustments.

Measuring and Motivating Quantity, Creativity, or Both

Abstract: We examine how worker productivity differs when compensation is based on quantity, creativity, or the product of both measures. In an experiment in which participants design “rebus puzzles,” we find that combining quantity and creativity measures in a creativity-weighted pay scheme results in creativity-weighted productivity scores that are significantly lower than those generated by participants with quantity incentives alone. Follow-up analysis indicates that relative to participants in the quantity-only condition, participants in the creativity-weighted condition produce approximately the same number of high-creativity puzzles, but produce significantly fewer puzzles overall. Thus, while participants rewarded for creativity-weighted output tend to restrict their production to high-creativity efforts, they are unable to translate this focus into a greater volume of high-creativity output. Implications address a possible explanation for firms' reluctance to incorporate creativity measures within multidimensional performance measurement systems, notwithstanding published suggestions to do so.

Regulation Fair Disclosure and the Cost of Adverse Selection

Abstract: Regulation Fair Disclosure (FD), imposed by the Securities and Exchange Commission in October 2000, was designed to prohibit disclosure of material private information to selected market participants. The informational advantage such select participants gain is unclear. If multiple “insiders” receive identical information, private information is immediately incorporated in price and each insider has zero expected profit. If, on the other hand, Regulation FD has curtailed the flow of information from firms, private information becomes longer-lived and more valuable. Hence, market makers will demand increased compensation by widening the adverse selection component of the bid-ask spread. We identify the cost components of the bid-ask spread for a sample of NASDAQ stocks surrounding the implementation of Regulation FD. Controlling for other factors affecting the spread, we find that adverse selection costs increase approximately 36% after Regulation FD. We interpret our finding as Regulation FD failing to achieve one of its desired objectives.

A Reexamination of the Tradeoff between the Future Benefit and Riskiness of R&D Increases

Abstract: Many previous studies document a positive relation between research and development (R&D) and equity value. Though R&D can increase equity value by increasing firm value, it can also increase equity value at the expense of bondholder wealth through an increase in firm risk because equity is analogous to a call option on the underlying firm value. Shi [2003] tests this hypothesis by examining the relation between a firm’s R&D intensity and its bond ratings and risk premiums at issuance. His results show that the net effect of R&D is negative for bondholders. We reexamine Shi’s [2003] findings and in so doing make three contributions to the literature. First, we find that Shi’s [2003] results are sensitive to the method of measuring R&D intensity. When we use what we argue is a better measure of R&D intensity, we find that the net effect of R&D is positive for bondholders. Second, when we use tests that Shi [2003] recognizes are even better than the ones that he uses, we find even stronger evidence of the positive effect of R&D on bondholders. Third, we examine cross-sectional differences in the effect of R&D on debtholders.

Overreaction to Intra-industry Information Transfers?

Abstract: Prior research has documented that earnings announcements provide information not only about the announcing firm but also about other firms in the same industry. We document a stock market anomaly associated with this phenomenon of intra-industry information transfers by showing that the stock price movements of late announcers in response to earnings reported by early announcers are negatively related to subsequent price responses of late announcers to their own earnings reports. Apparently, the stock market overestimates the intra-industry implications of early announcers' earnings for late announcers' earnings, and that overestimation is corrected when late announcers disclose their earnings.