Showing papers in "Journal of Business Finance & Accounting in 2017"

Predicting Corporate Bankruptcy: An Evaluation of Alternative Statistical Frameworks

Abstract: Corporate bankruptcy prediction has attracted significant research attention from business academics, regulators and financial economists over the past five decades (Altman, 2002). However, much of this literature has relied on quite simplistic classifiers such as logistic regression and linear discrminant analysis (LDA) (Jones and Hensher, 2008). Based on a large sample of US corporate bankruptcies, we examine the predictive performance of 16 classifiers, ranging from the most restrictive classifiers (such as logit, probit and linear discriminant analysis) to more advanced techniques such as neural networks, support vector machines (SVMs) and ‘new age’ statistical learning models including generalised boosting, AdaBoost and random forests. Consistent with the findings of Jones et al., (2015), we show that quite simple classifiers such as logit and LDA perform reasonably well in bankruptcy prediction. However, we recommend the use of ‘new age’ classifiers in corporate bankruptcy modelling because: (1) they predict significantly better than all other classifiers on both the cross-sectional and longitudinal test samples; (2) the models may have considerable practical appeal because they are relatively easy to estimate and implement (for instance, they require minimal researcher intervention for data preparation, variable selection and model architecture specification); and (3) while the underlying model structures can be very complex, we demonstrate that ‘new age’ classifiers have a reasonably good level of interpretability through such metrics as relative variable importances (RVIs). This article is protected by copyright. All rights reserved

Corporate social responsibility and firm financial risk reduction: On the moderating role of the legal environment

Abstract: Approaching the institutional environment through its regulative component, we distinguish between shareholder-oriented and stakeholder-oriented countries. Identifying first this classification with the distinction between common law versus civil law countries and using a large sample of 5,716 firm-year observations that represents 1,169 individual firms in 25 countries between 2001 and 2011, we show that Corporate Social Responsibility (CSR) significantly reduces firms’ idiosyncratic risk in civil law countries but not in common law countries. Using then a more direct classification based on shareholder and employee protection scores, our findings suggest that CSR negatively affects firms’ idiosyncratic and systematic risks only in less shareholder-oriented and more stakeholder-oriented countries, respectively. These findings are similar in the different components of CSR with two notable exceptions: a high score in corporate governance reduces firm risk only in common law countries, and community involvement increases idiosyncratic risk in more shareholder-oriented and less stakeholder-oriented countries, respectively. Taken together, our results strongly support the view that the relationship between CSR and financial risk is moderated by the institutional context of the firm.

Climate Change and Asset Prices: Are Corporate Carbon Disclosure and Performance Priced Appropriately?

Abstract: This paper empirically assesses the relevance of information on corporate climate change disclosure and performance to asset prices, and discusses whether this information is priced appropriately. ...

The BP Oil Spill: Shareholder Wealth Effects and Environmental Disclosures

Abstract: We use the BP oil spill to provide new evidence regarding the consequences of, and motivations for, environmental disclosures. We find that among oil and gas firms drilling in US waters, those with greater environmental disclosure suffered smaller negative shareholder wealth effects following the spill. This suggests that shareholders believed firms with more environmental disclosures were better prepared to address future environmental regulations and less likely to experience similar environmental incidents. We also document an increase in environmental disclosure, specifically disclosures of disaster readiness plans, in the year following the spill. Firms with poorer past environmental performance were more likely to increase disaster readiness plan disclosures. The increased disclosure by the poor pre-spill environmental performers is not entirely window dressing, as their post-spill environmental performance improved. The totality of our evidence is most consistent with the voluntary disclosure theory of environmental disclosure.

Tax avoidance and ex ante cost of capital

Abstract: This study examines the association between tax avoidance and ex ante cost of equity capital. Based on prior research, we develop two proxies for investors’ expectations of tax avoidance and explore whether deviations from those expectations result in higher ex ante cost of equity capital. We find that the ex ante cost of equity capital increases with tax avoidance that is either below or above investor expectations and that the increase is larger for tax avoidance that exceeds investors’ expectations. We then examine whether firms that alter their future tax avoidance exhibit a lowering of their ex ante cost of equity capital and find that tax avoidance decreases (increases) from the prior year for firms that were above (below) investors’ expectations in the prior year. These results are consistent with the trade-off suggested by the Scholes and Wolfson framework and reinforce the notion that balancing tax benefits and non-tax costs is an important feature of firms’ tax planning.

Effect of international working experience of individual auditors on audit quality: Evidence from China

Abstract: This paper investigates the effects of auditors with international working experience on audit quality in emerging markets. Such auditors are associated with better audit quality, a pattern that is further supported by an examination based on a propensity score matching sample that controls for endogeneity. Chief financial officers with international experience are more conservative in the client company of their auditors who have international working experience. Further, reviewer partners with international working experience provide better audit quality in terms of low accruals, less below-the-line items, and less audit reporting aggressiveness, while engagement partners with international working experience require high audit fees. Moreover, financial reports signed by auditors with international working experience significantly increase analyst forecast accuracy and decrease analyst forecast dispersion. Our results are robust to different specifications and alternative measures. Overall, this paper highlights the importance of human capital and provides direct evidence on how auditors with international working experience use their knowledge and audit skills in emerging markets.

Impression Management and Non-GAAP Disclosure in Earnings Announcements

Abstract: Funding: FCT-Foundation for Science and Technology in Portugal (grant nr. PTDC/EGE-GES/103770/2008), Spanish Ministry of Science and Innovation (grant nr. SEJ2007-67582-C02-02/ECON, ECO2010-19314), Ministerio de Economia y Competitividad (grant nr. 2014/00452/001), Comunidad Autonoma de Madrid (grant nr. SEJ2008-00059-003) and Nova Forum

Does It Pay to Communicate with Firms? Evidence from Firm Site Visits of Mutual Funds

Abstract: By using a unique dataset on mutual fund visits to listed firms in China, we investigate whether mutual funds are able to obtain private information or benefit from their communication with firms. Our findings are as follows: 1) such communication significantly increases the subsequent trading magnitude of mutual funds; 2) mutual fund trades that rely on communication significantly predict the unexpected earnings of visited firms, which is further supported by IV-regressions that use the number of direct flights between two cities as the instrument of communication; and 3) comprehensiveness of communication topics and firms’ information environment significantly affect the benefits that mutual funds obtain from communication. Our results are robust to alternative measures and specifications, and provide insights for regulators who are concerned with fair disclosure.

Overconfidence, CEO Awards, and Corporate Tax Aggressiveness

Abstract: Theory and prior research suggest that overconfidence leads managers to overestimate their own ability to generate returns, leading to riskier corporate policies. We use a novel dataset of media awards as an exogenous shock to overconfidence to test whether award-winning CEOs adopt more aggressive corporate tax policies. Using propensity score matching and a difference-in-difference design, we find strong evidence that firms with an award-winning CEO exhibit significantly greater tax aggressiveness following the award. Overall, our results suggest that CEO overconfidence has a meaningful impact on corporate tax policy.

The Role of Foreign Shareholders in Disciplining Financial Reporting

Abstract: We investigate the role of foreign shareholders in improving the quality of accounting information provided by firms domiciled in countries with low de facto institutional quality. Using a sample of firms from four South-European countries (Greece, Italy, Portugal and Spain) for which we observe detailed ownership evolutions over the period 2002–2007, we find that increases in foreign ownership lead to increases in financial reporting quality but only if the foreign shareholders are domiciled in countries with strong investor protection mechanisms. Further, we find that the improvement in financial reporting quality is more pronounced in the case of foreign institutional investors. Finally, our results hold before and after the introduction of the International Financial Reporting Standards (IFRS) in 2005. This article is protected by copyright. All rights reserved

Beyond Tax Avoidance: Offshore Firms’ Institutional Environment and Financial Reporting Quality*

Abstract: We explore how firms’ operations in Offshore Financial Centers (OFCs) through subsidiaries or affiliates affect the quality of financial reporting. Using a unique and large sample of firms that have headquarters in the 15 countries with the strictest legal regimes and have subsidiaries or affiliates in OFCs, we find that such firms exhibit lower financial reporting quality than comparable firms without OFC operations. We also find that as OFC characteristics become more prevalent, firms are more likely to engage in both accrual-based and real earnings management. More importantly, after disentangling OFC characteristics into the opportunity for tax avoidance, regulation arbitrage and secrecy policies, we find that beyond tax avoidance, regulation arbitrage and the secrecy policies of OFCs significantly affect financial reporting quality. The causal effect of OFC operations is supported by the analysis of financial reporting quality when firms set up OFC operations. Our findings are robust to various additional tests addressing potential endogeneity issues. We conclude that the assessment of a firm's institutional environment must encompass the registration status of its subsidiaries or affiliates as well as its own.

Does branch religiosity influence bank risk taking

Abstract: Using branch-level data on public and private US banking institutions, we investigate the importance of branch religiosity in shaping bank risk-taking behavior. Our results show robust evidence that branch religiosity is negatively related to bank risk-taking. This effect persists after controlling for several bank-level and county-level variables that might correlate with religiosity. Moreover, this result is robust to controlling for headquarter religiosity, suggesting that the effect of branch religiosity is additive and not washed out by headquarter religiosity. Overall, our findings document that headquarter religiosity does not capture the full effect of religiosity on bank behavior, as claimed by previous research, but that the religiosity of the geographic area in which the bank operates significantly influences bank behavior.

Corporate social responsibility and the assessment by auditors of the risk of material misstatement

Abstract: This paper investigates whether, and how, firms’ corporate social responsibility (CSR) performance influences the auditor's assessment of the risk of material misstatement, whether due to fraud or error, at the financial statement level by analysing their pricing decision (i.e., audit fees). Using a panel data set of 12,330 firms from 28 countries over the period 2003–2012 and different measures of CSR performance, we find a U-shaped relationship between firms’ CSR performance and audit fees. This result suggests that there is an optimal level of CSR performance that minimizes the auditor's assessment of the risk of material misstatement, which in turn lowers the need for greater auditor effort; that is why auditors charge firms significantly less when their CSR performance is at the optimal level. Finally, we also show that the optimal level of CSR performance varies with the degree of environmental dynamism, ownership concentration and leverage.

Credit Ratings and Earnings Management around IPOs

Abstract: This study examines the impact of having a credit rating on earnings management (EM) through accruals and real activities manipulation by initial public offering (IPO) firms We find that firms going public with a credit rating are less likely to engage in income-enhancing accrual-based and real EM in the offering year The monitoring by a credit rating agency (CRA) and the reduced information asymmetry due to the provision of a credit rating disincentivise rated issuers from managing earnings We also suggest that the participation of a reputable auditing firm is crucial for CRAs to effectively restrain EM Moreover, we document that for unrated issuers, at-issue income-increasing EM is not linked to future earnings and negatively related to post-issue long-run stock performance However, for rated issuers, at-issue income-increasing EM is positively associated with subsequent accounting performance and unrelated to long-run stock performance following the offering The evidence indicates that managers in unrated firms generally manipulate earnings to mislead investors, while managers in rated firms tend to exercise their accounting and operating discretion for informative purposes This article is protected by copyright All rights reserved

The Unintended Consequences of the Frequency of PCAOB Inspection

Abstract: After more than 50 years of self-regulation of the US auditing profession, the Sarbanes-Oxley Act of 2002 (SOX) created the Public Company Accounting Oversight Board (PCAOB) as a quasi-governmental entity with statutory authority to inspect accounting firms that audit public clients. The frequency of this inspection is annual or triennial, based upon the number of public clients the firm audits. We examine the effects of these two levels of inspection frequency on financial reporting quality and audit fees for clients of small and midsize public accounting firms. Our findings provide evidence of significantly higher audit quality and audit fees for clients of annually inspected firms relative to clients of triennially inspected firms. These findings are robust to auditor-client alignment analyses, propensity score matching, time-series analyses, examination of firms that have changed from triennial to annual inspection, and particular examination of firms with inspection deficiencies. Overall, our study suggests that the two-tier frequency system of PCAOB inspection may have also resulted in two-tier audit quality and audit fee systems for small and midsize public accounting firms, with more frequent inspection leading to more rigorous and informed auditor decisions. We discuss the implications of our results for the Board and the profession at large.

Auditor selection and corporate social responsibility

Abstract: This study examines the association between the selection of an industry specialist auditor and corporate social responsibility (CSR). We find that firms with higher CSR ratings are more likely to hire industry specialist auditors (national-level industry leaders, city-level industry leaders, or joint city-national industry leaders). Moreover, firms with better CSR performance related to product quality and the environment in controversial industries are found to select non-specialized auditors. The results suggest that such firms may overinvest in CSR activities associated with the environment and product issues to disguise the sin nature of their manufactured goods, and simultaneously engage low quality auditors perhaps to avoid full disclosure of potential environmental and legal liabilities. Overall, we conclude that CSR is associated with the non-controversial firms ensuring high quality financial reporting in response to societal expectations, and thus CSR firms in such industries have strong incentives to engage industry specialist auditors. This article is protected by copyright. All rights reserved

Controlling Shareholders’ Incentive and Corporate Tax Avoidance - A Natural Experiment in China

Abstract: The split share structure reform removes a significant market friction in China's capital market by allowing previously non-tradable shares to be freely tradable at market prices. Such a reform reduces the agency conflict between controlling shareholders and minority shareholders as the former now care more about stock prices. We find that state-owned firms, but not non-state-owned firms, significantly increased their tax avoidance activities after the reform. We attribute this differential effect to the dual role of the government as state-owned firms’ controlling shareholder as well as the tax claimant. Further, this effect is more pronounced for state-owned firms that are more likely to be influenced by the government prior to the reform. Finally, the reform reinforces a positive association between tax avoidance and firm value. Overall, our study suggests that when controlling shareholders are more concerned about stock prices, state-owned firms engage more in tax avoidance activities to enhance firm value.

National Culture and the Valuation of Cash Holdings

Abstract: Prior studies document that national culture traits are systematically related to cash holdings and attribute this to managerial cultural predispositions. However, it is possible that these preferences reflect investors’ cultural preferences and that managers are simply catering to investors’ preferences. It is also not clear whether the cash holding effects previously documented are value maximizing. By examining the impact of national culture traits on cash valuation we are able to provide insight into these questions. Specifically, we examine the effect of three national culture traits—individualism, uncertainty avoidance and long-term orientation—on firm cash valuation. Our results suggest that the previously observed effects of cultural traits on cash holdings and attributed to managerial cultural biases do not reflect investors’ preferences and are not value maximizing. This article is protected by copyright. All rights reserved

Does Stock Liquidity Affect Accrual‐based Earnings Management?

Abstract: This study investigates the effects of stock liquidity on earnings management. While prior research finds that liquidity has mixed effects on corporate governance, our baseline regression results show that an increase in stock liquidity is associated with an increase in discretionary accruals and revenues. To establish causality, we use two quasi-natural experiments that exploit exogenous increases in stock liquidity resulting from regulatory changes to the minimum tick size. The results of our difference-in-differences approach indicate that stock liquidity increases accrual-based earnings management. Additional analysis suggests that liquidity affects earnings management by magnifying the effects of takeover pressure and equity compensation.

Is Japan Really a “Buy”? The Corporate Governance, Cash Holdings and Economic Performance of Japanese Companies

Abstract: We investigate whether Japan's much-touted governance reforms improve its firms’ management of cash, economic performance and valuation. Consistent with an improvement in governance since 2000, Japanese firms hold less cash and increase payouts to shareholders. Improvements in performance are associated with reductions in (excess) cash, reductions in the influence of the banks that traditionally sit at the center of horizontal keiretsu, and increases in the holdings of management and foreign investors. The market valuation of Japanese firms’ cash holdings was lower than for US firms during the 1990s but increased to levels closer to those of US firms in the 2000s. Collectively, the evidence suggests that performance improves in those Japanese companies that reform their governance practices. These findings have implications for other Asian economies, such as China, India and Korea, where there are ongoing discussions of whether improved governance can increase firm performance and valuation.

The Effects of Disclosure and Analyst Regulations on the Relevance of Analyst Characteristics for Explaining Analyst Forecast Accuracy

Abstract: We posit and find an effect of disclosure and analyst reporting regulations implemented from 2000 through 2003 (including Regulation Fair Disclosure, the Sarbanes-Oxley Act, and the Global Settlement Act) on the importance of analyst and forecast characteristics for analyst forecast accuracy. Following the enactment of these regulations, more experienced analysts and All-Star analysts do not maintain their superior forecast accuracy, and analysts employed by large brokerage houses perform worse than other analysts. In addition, we find a decrease in the importance of analyst effort, the number of industries and firms followed, days elapsed since the last forecast, and forecast horizon. While the importance of bold upward forecast revisions does not change, bold downward revisions lose their relevance for forecast accuracy after 2003. Finally, we find an increase in the important of prior forecast accuracy. We find that the importance of these characteristics varies with the precision of publicly available information. Specifically, the decrease in the importance of most analyst and forecast characteristics and the increase in the importance of prior forecast accuracy are greater when the precision of publicly available information is low. Overall, our results suggest that the positive effects of experience, effort, brokerage house size, and All-Star status on forecast accuracy in the pre-regulation period were because of the information advantages that these analysts enjoyed (rather than their ability to generate private information). In contrast, our results suggest that prior forecast accuracy is related to analysts’ ability to generate private information. This article is protected by copyright. All rights reserved

Corporate Innovation Strategy, Analyst Forecasting Activities and the Economic Consequences

Abstract: We examine the impact of corporate innovation strategy on analyst following and forecasting performance, as well as the associated economic consequences. Using a sample of US firms from 1992−2012, we find that firms pursuing an exploration‐oriented innovation strategy (as opposed to an exploitation‐oriented innovation strategy) are associated with lower analyst coverage, higher forecast error and dispersion. The effect is less pronounced for firms with greater disclosure of innovation activities, and for firms followed by analysts with more firm‐specific experience. We also examine how innovation strategy affects the perceived credibility of analyst forecasts and find that investors appear to be less responsive to forecast revisions issued for exploratory firms. Such firms also incur a higher level of cash holdings, greater internal financing, and lower dividend ratio. The findings of this paper advance our understanding of how a public company's choice of innovation strategy affects its performance in the capital markets as well as the associated economic consequences.

Related Party Transactions, Corporate Governance and CEO Compensation

Abstract: Examining the years 2001–2012, we document a decrease in reported CEO related party transactions (RPTs) and an increase in reported outside director RPTs, with the largest change occurring around the 2006 Securities and Exchange Commission (SEC) RPT disclosure changes. Our analysis of the determinants of RPTs and their association with CEO compensation also shows an impact of the SEC disclosure change, as we find support for the weak governance hypothesis in the pre-2006 period and some support for the efficient contracting hypothesis post-2005. While our results vary by model, pre-2006, consistent with weak governance we find that outside director RPTs are positively associated with CEO compensation, with our estimates of the impact ranging from 8 to 18% depending on the model. In the post-2005 period, this result dissipates, and we find some evidence consistent with the efficient contracting hypothesis. Overall we find that the SEC RPT disclosure change appears to have had a significant impact on reported RPTs, the determinants of those RPTs, and the impact of those RPTs on CEO compensation.

Balance sheet conservatism and audit reporting conservatism

Abstract: Financial reports are prepared on a going-concern (GC) basis rather than a liquidation basis even when companies are highly distressed. This allows distressed companies to report book values of assets that greatly exceed their liquidation values, implying a lack of conservatism in the balance sheet. We argue that auditors issue going-concern opinions in order to warn investors about this lack of balance sheet conservatism. This argument leads to two testable hypotheses. First, for companies that are at risk of bankruptcy, auditors are more likely to issue GC opinions when the book values of assets under the GC assumption are high relative to the expected liquidation values of assets (i.e., when the GC assumption causes the balance sheet to lack conservatism). Second, for companies that enter bankruptcy, the issuance of a prior GC opinion has predictive information content with respect to the wedge between the book values of assets and the future liquidation values of those same assets. Our results strongly support both hypotheses. The findings are important because they indicate that conservative audit reporting helps to compensate for a lack of conservatism in the balance sheet, which arises because the GC assumption permits the book values of assets to exceed their liquidation values.

How does the Funding Status of Defined Benefit Pension Plans Affect Investment Decisions of Firms in the United States

Abstract: We investigate whether the flexibility in making contributions towards defined benefit pension plans sponsored by firms in the United States allows managers to save cash and increase investments. Firms invest more at higher levels of pension deficit, defined as pension benefit obligations less pension assets, and scaled by total assets. At the median level (90th percentile) of pension deficit, investment increase by 6.7 cents (9.4 cents) for every dollar increase in cash. As the pension deficit increases, firms deviate more from the predicted level of investment. These findings suggest that the incremental investments are more likely to represent overinvestment by managers. Our results are robust to alternative model specifications and endogeneity concerns that may arise if investments are jointly determined with the funding policy of pension plans and the firm's target cash level. We repeat our main analysis for the United Kingdom (UK) and also find for that country that, at a fixed cash level, total investment increases as pension deficit increases. This article is protected by copyright. All rights reserved

Corporate Lobbying, Visibility and Accounting Conservatism

Abstract: In this study, we examine the relationship between a firm's lobbying activities and financial reporting quality using a US setting where public scrutiny of corporate political activities is high. More importantly, we examine whether and how a firm's visibility shapes the relationship between its corporate lobbying activities and accounting conservatism. Adopting annual lobbying expenditure data to measure firms’ lobbying activities, and using a propensity-score-matching methodology to control for differences in firm characteristics between lobbying and non-lobbying firms, we find a positive relationship between a firm's lobbying intensity and the degree of accounting conservatism in its financial reporting. We further find this positive relationship to be more pronounced in lobbying firms with a higher level of visibility. These results are robust after controlling for a firm's political connections, across various conditional conservatism measures, and across a number of visibility measures including firm size, the number of analysts following the firm, the age of the firm, the number of foreign stock exchanges that the firm is cross-listed in, and the level of the firm's media coverage. Together, our findings add to the literature on how firms’ political activities shape their accounting practices in general, and accounting conservatism in particular. More importantly, our findings suggest that the heightened public attention paid to political activities in the US yields incentives for firms to be more conservative in their accounting practices.

Managerial Discretion in Accruals and Informational Efficiency

Abstract: In this paper, we examine the relation between managerial discretion in accruals and informational efficiency. We measure managerial discretion in accruals by the absolute value of abnormal accruals. Assuming that efficient prices follow a random walk, we measure informational efficiency by using stock return variance ratios. We find that the absolute value of abnormal accruals is negatively associated with the price deviation from a random walk pattern, estimated in the 12-month period subsequent to the accrual reporting; hence, future informational efficiency increases with the extent to which managers exercise discretion over accruals. The results are consistent with the view that discretionary accruals, on average, convey useful information to investors and facilitate the price convergence to its fundamental value. Our findings are robust to a battery of tests, including tests to validate both our measures of informational efficiency and our measure of managerial discretion in accruals.

Earnings quality and short selling: Evidence from real earnings management in the United States

Abstract: Prior research provides evidence consistent with managers using real earnings management (REM) to increase earnings. This study examines whether short sellers exploit the overvaluation of firms employing REM. I find that firms with more REM have higher subsequent short interest. The positive relation between REM and short interest is more pronounced in settings where the costs associated with accrual-based earnings management are high, such as when a firm has low accounting flexibility or faces greater scrutiny from a high quality auditor. I also find some evidence that short sellers respond to REM more than to other fundamental signals of firm overvaluation. My inferences are robust to the use of propensity score matching. Collectively, my evidence suggests that short sellers not only trade on REM information, but they also trade as if they understand the substitutive nature of alternative earnings management methods. This study provides additional insight into the important role that short sellers play in monitoring managerial operating decisions and overall earnings quality.

The CDS market reaction to restatement announcements

Abstract: I investigate the credit market's reaction to restatement announcements through changes in credit default swap (CDS) spreads. I document an overall positive association between CDS returns and restatement announcements. Specifically, I find that more positive CDS returns are associated with restatements (1) involving fraud and (2) affecting more accounts. Moreover, these reactions are sensitive to the underlying entities’ credit ratings and the market-wide investor sentiment. Next, I compare CDS and stock market reactions and find that more negative stock returns are associated with restatements (1) involving fraud and (2) decreasing reported income.