Showing papers in "Journal of Accounting Research in 2014"

Political connections and the cost of bank loans

Abstract: This paper analyzes whether the political connections of listed firms in the United States affect the cost and terms of loan contracts. Using a hand-collected data set of the political connections of S&P 500 companies over the 2003-2008 time period, we find that the cost of bank loans is significantly lower for companies that have board members with political ties. We consider two possible explanations for these findings: a Borrower Channel in which lenders charge lower rates because they recognize that connections enhance the borrower's credit worthiness and a Bank Channel in which banks assign greater value to connected loans to enhance their own relationships with key politicians. After employing a series of tests to distinguish between these two channels, we find strong support for the Borrower Channel but no direct evidence supporting the Bank Channel. Finally, we demonstrate that political connections reduce the likelihood of a capital expenditure restriction or liquidity requirement commanded by banks at the origination of the loan. Taken together, our results suggest that political connections increase the value of U.S. companies and reduce monitoring costs and credit risk faced by banks, which, in turn, reduces the borrower's cost of debt.

Private interaction between firm management and sell-side analysts

Abstract: Although sell-side analysts often privately interact with managers of publicly traded firms, the private nature of this contact has historically obscured direction examination. By examining a set of proprietary records compiled by a large-cap NYSE-traded firm, I offer insights into which analysts privately meet with management, when analysts privately interact with management, and why these interactions occur. I also compare private interaction to public interaction between analysts and managers on conference calls. The evidence suggests that private interaction with management is an important communication channel for analysts for reasons other than firm-specific forecasting news

Auditor Choice in Politically Connected Firms

Abstract: We extend recent research on the links between political connections and financial reporting by examining the role of auditor choice. Our evidence that public firms with political connections are more likely to appoint a Big 4 auditor supports the intuition that insiders in these firms are eager to improve accounting transparency to convince outside investors that they refrain from exploiting their connections to divert corporate resources. In evidence consistent with another prediction, we find that this link is stronger for connected firms with ownership structures conducive to insiders seizing private benefits at the expense of minority investors. We also find that the relation between political connections and auditor choice is stronger for firms operating in countries with relatively poor institutional infrastructure, implying that tough external monitoring by Big 4 auditors becomes more valuable for preventing diversion in these situations. Finally, we report that connected firms with Big 4 auditors exhibit less earnings management and enjoy greater transparency, higher valuations, and cheaper equity financing.

When the Use of Positive Language Backfires: The Joint Effect of Tone, Readability, and Investor Sophistication on Earnings Judgments

Abstract: Recent studies document that market participants react positively to the positive language sentiment or tone embedded in financial disclosures, and that investors' reactions to negative news are more muted with poor disclosure readability. However, while language sentiment and readability co-occur in practice, their joint effects remain largely unexplored. In an experiment with MBA students as participants, we investigate how the effect of language sentiment varies with readability and investor sophistication level. We find that language sentiment influences investors' judgments when readability is low, but not when readability is high. Specifically, when readability is low, disclosures couched in positive language lead to higher earnings judgments for less sophisticated investors, but lower earnings judgments for more sophisticated investors. These findings show that the main effects of readability and language sentiment documented in prior studies have boundary effects, and may reverse when both variables are jointly considered along with investor sophistication

Masculinity, Testosterone, and Financial Misreporting

Abstract: We examine the relation between a measure of male CEOs� facial masculinity and financial misreporting. Facial masculinity is associated with a complex of masculine behaviors (including aggression, egocentrism, riskseeking, and maintenance of social status) in males. One possible mechanism for this relation is that the hormone testosterone influences both behavior and the development of the face shape. We document a positive association between CEO facial masculinity and various misreporting proxies in a broad sample of S&P1500 firms during 1996�2010. We complement this evidence by documenting that a CEO's facial masculinity predicts his firm's likelihood of being subject to an SEC enforcement action. We also show that an executive's facial masculinity is associated with the likelihood of the SEC naming him as a perpetrator. We find that facial masculinity is not a measure of overconfidence. Finally, we demonstrate that facial masculinity also predicts the incidence of insider trading and option backdating.

Accounting Standards Harmonization and Financial Statement Comparability: Evidence from Transnational Information Transfer

Abstract: This paper investigates whether accounting standards harmonization enhances the comparability of financial information across countries. I hypothesize that a firm yet to announce earnings reacts more strongly to the earnings announcement of a foreign firm when both report under the same rather than different accounting standards. My analysis of abnormal price reactions for a global sample of firms supports the prediction. Next, in an attempt to control for the underlying economic comparability and the effects of changes in reporting quality, I use a difference-in-differences design around the mandatory introduction of International Financial Reporting Standards. I find that mandatory adopters experience a significant increase in market reactions to the release of earnings by voluntary adopters compared to the period preceding mandatory adoption. This increase is not observed for nonadopters. Taken together, the results show that accounting standards harmonization facilitates transnational information transfer and suggest financial statement comparability as a direct mechanism.

Trust and Financial Reporting Quality

Abstract: Using unique survey data from Great Place to Work® Institute, we investigate the association of intraorganizational trust (i.e., employees� trust in management) with three aspects of financial reporting: accruals quality, misstatements, and internal control quality. We find that trust is associated with better accrual quality, lower likelihood of financial statement misstatements, and lower likelihood of internal control material weakness disclosures. However, these effects are not uniform across all companies. Consistent with trust improving financial reporting quality through improved information production and information sharing, we find that trust is significantly associated with financial reporting quality in relatively decentralized firms, but not in firms that are relatively centralized. Our results are robust to several analyses that attempt to control for potential alternative explanations.

How Frequent Financial Reporting Can Cause Managerial Short-Termism: An Analysis of the Costs and Benefits of Increasing Reporting Frequency

Abstract: We develop a cost�benefit tradeoff that provides new insights into the frequency with which firms should be required to report the results of their operations to the capital market. The benefit to increasing the frequency of financial reporting is that it causes market prices to better deter investments in negative net present value projects. The cost of increased frequency is that it increases the probability of inducing managerial short-termism. We analyze the tradeoff between these costs and benefits and develop conditions under which greater reporting frequency is desirable and conditions under which it is not.

Public Equity and Audit Pricing in the United States

Abstract: To what degree are audit fees for U.S. firms with publicly traded equity higher than fees for otherwise similar firms with private equity? The answer is potentially important for evaluating regulatory regime design efficiency and for understanding audit demand and production economics. For U.S. firms with publicly traded debt, we hold constant the regulatory regime, including mandated issuer reporting and auditor responsibilities. We vary equity ownership and thus public securities market contextual factors, including any related public firm audit fees from increased audit effort to reduce audit litigation risk and/or pure litigation risk premium (litigation channel effects). In cross-section, we find that audit fees for public equity firms are 20�22% higher than fees for otherwise similar private equity firms. Time-series comparisons for firms that change ownership status yield larger percentage fee increases (decreases) for those going public (private). Results are consistent with litigation channel effects giving rise to substantial incremental audit fees for U.S. firms with public equity ownership.

Dividend payouts and information shocks

Abstract: We examine changes in firms� dividend payouts following an exogenous shock to the information asymmetry problem between managers and investors. Agency theories predict a decrease in dividend payments to the extent that improved public information lowers managers� need to convey their commitment to avoid overinvestment via costly dividend payouts. Conversely, dividends could increase if minority investors are in a better position to extract cash dividends. We test these predictions by analyzing the dividend payment behavior of a global sample of firms around the mandatory adoption of IFRS and the initial enforcement of new insider trading laws. Both events serve as proxies for a general improvement of the information environment and, hence, the corporate governance structure in the economy. We find that, following the two events, firms are less likely to pay (increase) dividends, but more likely to cut (stop) such payments. The changes occur around the time of the informational shock, and only in countries and for firms subject to the regulatory change. They are more pronounced when the inherent agency issues or the informational shocks are stronger. We further find that the information content of dividends decreases after the events. The results highlight the importance of the agency costs of free cash flows (and changes therein) for shaping firms� payout policies.

The relation between reporting quality and financing and investment: : evidence from changes in financing capacity.

Abstract: We use changes in the value of a firm's real estate assets as an exogenous change in a firm's financing capacity to examine (1) the relation between reporting quality and financing and investment conditional on this change, and (2) firms’ reporting quality responses to the change in financing capacity. We find that financing and investment by firms with higher reporting quality is less affected by changes in real estate values than are financing and investment by firms with lower reporting quality. Further, firms increase reporting quality in response to decreases in financing capacity. Our findings contribute to the literature on reporting quality and investment, and on the determinants of reporting quality choices.

The Effects of Uncertainty and Disclosure on Auditors' Fair Value Materiality Decisions

Abstract: Financial accounting standards increasingly require fair value measurements. I experimentally examine how uncertainty affects auditors’ adjustment decisions when evaluating fair values. I manipulate two types of uncertainty, input subjectivity and outcome imprecision, and one reporting choice, supplemental disclosure. I find that auditors are most likely to require adjustments when fair values contain both more input subjectivity and more outcome imprecision, but that this likelihood diminishes when clients supplement recognized fair values with additional disclosure. Thus, consistent with moral licensing, I find that auditors tolerate greater potential misstatement in the financial statements when clients provide disclosure, suggesting that the SEC's preference for supplemental disclosure may have the unintended consequence of affecting fair values recognized in the body of the financial statements. I also provide evidence that auditors determine adjustment size by comparing recorded fair value to the nearest bound, rather than the midpoint, of the auditors’ own range estimate, consistent with strict application of auditing standards.

Debtholders’ Demand for Conservatism: Evidence from Changes in Directors’ Fiduciary Duties

Abstract: Debtholders� demand has been widely discussed as a key determinant of conservatism but clear causal evidence is not yet established. Using a natural experiment setting, wherein a Delaware court ruled that the fiduciary duties of directors in near insolvent Delaware companies extend to creditors, we predict and find that firms subject to the ruling significantly increased their accounting conservatism. In addition, our results suggest that the increase in conservatism is more pronounced in near insolvent Delaware firms with stronger boards, confirming that the court ruling takes effect through the channel of the board of directors. Our results are robust to using alternative measures of conservatism and near insolvency status, and controlling for potential confounding factors and other stakeholders� demand for conservatism. Overall, our study provides empirical evidence to support the causal relation between debtholders� demand and accounting conservatism previously suggested in the literature, and offers some insights into the role of the board of directors in financial reporting.

Do Declines in Bank Health Affect Borrowers’ Voluntary Disclosures? Evidence from International Propagation of Banking Shocks

Abstract: I examine whether declines in banks� financial health affect their borrowers� disclosures. Prior studies indicate that, in relationship lending, banks and borrowers rely on private communication, rather than public disclosures, to resolve information asymmetries. When banking relationships are threatened, borrowers must turn to new funding sources, inducing them to reconsider their disclosure policies. This paper predicts that borrowers, whose banking relationships are threatened by declining bank health, change their public disclosures of forward-looking information. Using the emerging-market financial crises in the late 1990s as shocks to the health of certain U.S. banks, I find that affected banks� U.S. borrowers increase both the quantity and informativeness of their management forecasts following these shocks compared to borrowers of unaffected banks. The results are similar using conference calls or the length of the Management's Discussion and Analysis section as alternative proxies for voluntary disclosure. Overall, these results provide new insights into the impact of availability of relationship lending on firms� disclosure choices.

Do Joint Audits Improve or Impair Audit Quality?: DO JOINT AUDITS IMPROVE OR IMPAIR AUDIT QUALITY?

Abstract: Conventional wisdom holds that joint audits would improve audit quality by enhancing audit evidence precision because �Two heads are better than one.� Our paper challenges this wisdom. We show that joint audits by one big firm and one small firm may impair audit quality, because, in that situation, joint audits induce a free-riding problem between audit firms and reduce audit evidence precision. We further derive a set of empirically testable predictions comparing audit evidence precision and audit fees under joint and single audits. This paper, the first theoretical study of joint audits, contributes to a better understanding of the economic consequences of joint audits on audit quality.

Are Trade Size‐Based Inferences About Traders Reliable? Evidence from Institutional Earnings‐Related Trading

Abstract: The use of observed transaction sizes to differentiate between �small� and �large� investor trading patterns is widespread. A significant concern in such studies is spurious effects attributable to misclassification of transactions, particularly those originating from large investors. Such effects can arise unintentionally, strategically, or endogenously. We examine comprehensive records of a sample of institutional investors (i.e., �large� traders), including their order sizes and overall position changes, to assess the degree to which such misclassifications give rise to spurious inferences about �small� and �large� investor trading activities. Our analysis shows that these institutions are heavily involved in small transaction activity. It also shows that they increase their order sizes substantially in announcement periods relative to nonannouncement periods, presumably as an endogenous response to earnings news. In the immediate earnings announcement period, transaction size-based inferences about directional trading are quite misleading�producing spurious �small trader� effects and, more surprisingly, erroneous inferences about �large trader� activity.

Economic Determinants and Information Environment Effects of Earnouts: New Insights from SFAS 141(R)

Abstract: Contingent considerations (earnouts) in acquisition agreements provide sellers with future payments conditional on meeting certain conditions. Prior research provides evidence that acquiring firms use earnouts to minimize agency costs associated with acquisitions. Using earnout fair value information, recently mandated by SFAS 141(R), we provide new insights into the economic determinants to include earnout provisions in acquisition agreements, including motivations to resolve moral hazard and adverse selection problems, bridge valuation gaps, and retain target firm managers. We document variations in initial earnout fair value estimates and earnout fair value adjustments that correspond with these underlying motivations. We also provide evidence that target managers stay longer with the firm after the acquisition when earnouts are included primarily to retain target managers. Finally, we demonstrate that earnout fair value adjustments required by SFAS 141(R) provide valuable information to market participants and are negatively associated with the likelihood of contemporaneous and future goodwill impairments.

Optimal Contracts with Performance Manipulation

Abstract: We study optimal compensation contracts that (1) are designed to address a joint moral hazard and adverse selection problem and that (2) are based on performance measures, which may be manipulated by the agent at a cost. In the model, a manager is privately informed about his productivity prior to being hired by a firm. In order to incentivize the manager to exert productive effort, the firm designs a compensation contract that is based on reported earnings, which can be manipulated by the manager. Our model predicts that (1) the optimal compensation contract is convex in reported earnings; (2) the optimal contract is less sensitive to reported earnings than it would be absent the manager's ability to manipulate earnings; and (3) higher costs of manipulating reported earnings (e.g., due to higher governance quality) are associated with higher firm value, lower expected level of earnings management, and higher output.

Advantageous Comparison and Rationalization of Earnings Management

Abstract: This paper proposes that psychological factors can change managers' beliefs about earnings management when they choose to engage in it. I show that, under certain circumstances, engaging in a small amount of earnings management alters a manager's beliefs about the appropriateness of the act, which may increase the likelihood of further earnings management. Specifically, I predict and find in two experiments that participants who initially choose to manage earnings are motivated to rationalize their behavior. Participants who are exposed to an egregious example of earnings management (commonly the focus of enforcement actions and press reports) have the opportunity to rationalize their behavior through a mechanism called �advantageous comparison,� where participants compare their behavior against the egregious example and conclude that what they did was relatively innocuous and appropriate. My analysis also indicates that presenting participants with an example of earnings management that is similar to the initial decision they made mitigates advantageous comparison. These results have implications for academics interested in how earnings management, and perhaps fraud, can accrete over time and for regulators and practitioners who are interested in preventing it.

Did Regulation Fair Disclosure, SOX, and Other Analyst Regulations Reduce Security Mispricing?

Abstract: Between 2000 and 2003 a series of disclosure and analyst regulations curbing abusive financial reporting and analyst behavior were enacted to strengthen the information environment of U.S. capital markets. We investigate whether these regulations reduced security mispricing and increased stock market efficiency. After the regulations, we find a significant reduction in short-term stock price continuation following analyst forecast revisions and earnings announcements. The effect was more pronounced among higher information uncertainty firms, where we expect security valuation to be most sensitive to regulation. Analyst forecast accuracy also improved in these firms, consistent with reduced mispricing being due to an improved corporate information environment following the regulations. Our findings are robust to controls for time trends, trading activity, the financial crisis, analyst coverage, delistings, and changes in information uncertainty proxies. We find no concurrent effect among European firms and a regression discontinuity design supports our identification of a regulatory effect.

The Impact of Recognition Versus Disclosure on Financial Information: A Preparer's Perspective

Abstract: We investigate whether recognition on the face of the financial statements versus disclosure in the footnotes influences the amount that financial managers report for a contingent liability. Using an experiment with corporate controllers and chief financial officers, we find that financial managers in public companies expend more cognitive effort and exhibit less strategic bias under recognition than disclosure. This difference appears to be associated with capital market pressures experienced by public company managers as we find that both the cognitive effort and bias exhibited by private company managers are unaffected by placement. As a result, public company managers make higher liability estimates for recognized versus disclosed liabilities. Their liability estimates are similar to those of private company managers for recognition but lower than private company managers� estimates for disclosure. Our results have implications for auditors and financial statement users in evaluating recognized versus disclosed information for public and private companies.

Are Auditors Professionally Skeptical? Evidence from Auditors’ Going‐Concern Opinions and Management Earnings Forecasts

Abstract: We examine whether auditors exercise professional skepticism about management earnings forecasts when making going-concern decisions. Using publicly issued management earnings forecasts as a proxy for earnings forecasts provided by managers to auditors, we find that management earnings forecasts are negatively associated with both auditors� going-concern opinions and subsequent bankruptcy. The weight auditors put on management forecasts in the going-concern decision is not significantly different from the weight implied in the bankruptcy prediction model. Moreover, compared with the bankruptcy model, auditors assign a lower weight to management forecasts they perceive as being less credible, including those (1) issued by managers who issued optimistic forecasts in the previous two years, and (2) predicting high earnings increases or high earnings. Taken together, our evidence is consistent with auditors being professionally skeptical about management earnings forecasts when making going-concern decisions.

Management forecast consistency

Abstract: We posit that management forecasts, which are predictable transformations of realized earnings without random errors, are more informative than unbiased forecasts, which manifest small but unpredictable errors, even if biased forecasts are less accurate. Consistent with this intuition, we find that managers who make consistent forecasting errors have a greater ability to influence investor reactions and analyst revisions, even after controlling for the effect of accuracy. This effect is more economically significant and statistically robust than that of forecast accuracy. More sophisticated investors and experienced analysts are found to have a better understanding of the benefits of consistent management forecasts.

The Effects of Public Information with Asymmetrically Informed Short-Horizon Investors

Abstract: This paper analyzes the effects of public information in a perfect competition trading model populated by asymmetrically informed short-horizon investors with different levels of private information precision. We first show that information asymmetry reduces the amount of private information revealed by price in equilibrium (i.e., price informativeness) and can lead to multiple linear equilibria. We then demonstrate that the presence of both information asymmetry and short horizons provides a channel through which public information influences price informativeness and equilibrium uniqueness. We identify conditions under which public information increases or decreases price informativeness, and when multiple equilibria may arise. Our analysis shows that public information not only directly endows prices with more (public) information, it can also have an important indirect effect on the degree to which prices reveal private information.

Incorporating Field Data into Archival Research

Abstract: I explore the use of field data in conjunction with archival evidence by examining Iliev, Miller, and Roth’s [2014] analysis of an amendment to the Securities Exchange Act of 1934. This regulatory amendment allowed depositary banks to cross-list firms without the cooperation of foreign issuers. Iliev, Miller, and Roth [2014] argue that the regulation failed to fulfill its intended purpose and imposed significant costs on foreign firms for the benefit of depositary banks. Drawing on evidence from lawyers, issuers, depositary banks, and regulators involved in the design and implementation of the amendment, I describe a more optimistic assessment of the amendment and its effects on capital markets. I conclude by discussing opportunities for field data in financial reporting and disclosure research.

Uninvited U.S. Investors? Economic Consequences of Involuntary Cross-listings

Abstract: We study the economic consequences of a recent Securities and Exchange Commission securities regulation change that grants foreign firms trading on the U.S. over-the-counter (OTC) market an automatic exemption from the reporting requirements of the 1934 Securities Act. We document that the number of voluntary (sponsored) OTC cross-listings did not increase following the regulation change, suggesting that it did not achieve its intended purpose of increasing voluntary OTC cross-listings through a reduction in compliance costs. We do find that the design of the regulation allowed financial intermediaries to create an unprecedented number of involuntary (unsponsored) OTC ADRs: 1,700 unsponsored ADR programs for 920 firms were created for companies that had previously chosen not to cross-list in the United States. Our difference-in-differences analysis based on a matched sample approach documents that foreign firms forced into the U.S. capital markets experience a significant decrease in firm value, and we further show that the decrease in firm value is related to an increase in U.S. litigation risk. We also find that depositary banks� propensity to involuntarily cross-list firms is positively related to banks� expected fee revenue, and that banks chose firms that incur high costs when involuntarily cross-listed. Our results provide evidence that securities regulation can be exploited for private gain and result in costly unintended consequences.

Sell-side analyst research and stock comovement

Abstract: We document that a stock's price around a recommendation or forecast covaries with prices of other stocks the issuing analyst covers. The effect of shared analyst coverage on stock price comovement extends beyond analyst activity days. A stock's daily returns covary with the returns of other stocks with which it shares analyst coverage. These links between stock price comovement and shared analyst coverage are consistent with the coverage-specific information we find in earnings forecasts; analysts who cover both stocks in a pair expect future earnings of the stocks to be more highly correlated than do analysts who cover only one stock from the pair. Collectively, our evidence indicates that analyst research produces coverage-specific spillovers that raise price comovement among stocks that share analyst coverage. The strength of these spillovers is comparable to spillovers from broad industry and market information in analyst research.

Aggregate Earnings and Corporate Bond Markets

Abstract: I examine the previously unexplored relation between aggregate earnings changes and corporate bond market returns. I find that aggregate earnings changes have a negative relation to investment-grade corporate bond market returns and a positive relation to high-yield corporate bond market returns. The aggregate earnings-returns relation is lower (i.e., less positive or more negative) for bonds with higher credit ratings and longer maturities. Further, I show that the aggregate earnings-returns relation is driven by both the expected and the news component of aggregate earnings changes. The expected component is negatively related to expected returns, and the news component is positively related to cash flow news and changes in nominal interest rates, and negatively related to changes in default premia. My results contribute to the understanding of the role of earnings in corporate bond markets as well as the macroeconomic role of accounting information.

Issues in Examining the Effect of Auditor Litigation on Audit Fees

Abstract: A large body of research has studied audit fees aiming to determine whether they reflect auditors’ response to clients’ risks, auditors’ expertise, competitive pressures in the audit market, and independence issues between auditors and clients. Badertscher, Jorgensen, Katz, and Kinney [2014] study the effect of auditor litigation risk on audit fees. Litigation risk is expected to be a strong incentive for auditors to deliver high quality audits and an important determinant of audit fees. Nevertheless, determining the impact of litigation risk is complicated because although there is considerable variation in audit fees, there are scarce opportunities to examine variation in litigation risk. This paper provides a brief summary of extant studies examining the effect of auditor litigation on audit fees, and discusses research design issues and future research opportunities in this area.