This article examines whether a corporate disclosure practice is one of the reasons for the forecast dispersion anomaly—the negative relation between analyst forecast dispersion and future stock returns. Prior studies have shown that firms tend to delay the disclosure of bad news and that withholding of news leads to greater dispersion in analysts’ forecasts. Accordingly, we predict that firms with higher dispersion in analysts’ earnings forecasts are more likely to experience poor earnings in the subsequent quarter, and find evidence consistent with this prediction. After controlling for the relation between forecast dispersion and future earnings, we find that forecast dispersion is no longer significantly negatively related to future stock returns. These results suggest that temporary withholding of bad news by firms increases forecast dispersion among analysts and leads to low subsequent stock returns.
We examine the association of insider ownership with financial analysts’ forecast accuracy and dispersion in a sample of U.S. dual-class firms. Insider ownership exerts two effects: a positive incentive effect and a negative entrenchment effect. The lack of significant findings in prior research regarding the association between insider ownership and forecast accuracy may be attributable to the offsetting forces of these two effects. Using a comprehensive hand-collected sample of U.S. firms that maintain more than one class of common stock, we are able to disentangle incentive and entrenchment effects which are confounded in single-class firms. We find that disproportionate insider control is negatively associated with forecast accuracy and positively associated with forecast dispersion. Moreover, insider cash flow rights (insider voting rights) are positively (negatively) associated with forecast accuracy and negatively (positively) associated with forecast dispersion, consistent with incentive-alignment and entrenchment effects of ownership affecting financial analysts’ forecasting environment in opposite directions.
This study examines (a) whether other comprehensive income (OCI) is more value relevant when reported in a more prominent and transparent location in financial statements, (b) how economic condition affects value relevance of OCI reported in different locations, and (c) whether value relevance of OCI is affected by the implementation of Accounting Standard Update (ASU) 2011-05, which requires reporting OCI in either a combined statement of income and comprehensive income or a separate statement of comprehensive income (SCI), and prohibits reporting OCI only in the statement of changes in shareholders’ equity (SSE). Using manually collected data for the period 2000-2012, we find that investors consistently priced OCI reported in the SSE during the entire test period. We also find that investors priced OCI reported in the SCI only during recent financial crisis period (2007-2009) when the magnitude and volatility of OCI significantly increased. Further evidence shows that this finding is not driven by the investment bias of transient investors. Finally, we find that value relevance of OCI decreases for firms that changed the reporting location of OCI from SSE to SCI following the implementation of ASU 2011-05 compared with firms that did not change the reporting location. As investors are expected to be more capable of incorporating information reported in a more transparent location into price, this study explores some plausible explanations for the puzzling finding and calls for future research.
Post-SOX (Sarbanes–Oxley Act) academic research on internal control focuses on the characteristics of publicly listed companies disclosing material control weaknesses or the consequences experienced by these companies. However, to date, limited research has empirically examined whether these new disclosures truly enhance "public interest" by promoting "equity" in the capital markets through enhanced information distribution. In this article, we empirically investigate the impact these disclosures have on information asymmetry and related market micro-structure. We hypothesize that both the management’s and the auditor’s reporting on internal control provide outside investors additional and higher quality information about a firm’s future prospects, thereby reducing the information asymmetry in capital markets. Such reduction in information asymmetry should be reflected in decreased bid-ask spreads and price volatility, as well as increased trading volume. Our cross-sectional analyses show that, subsequent to the management’s report on internal control per Section 302, the information environment improves for U.S. firms as manifested by decreased bid-ask spread and price volatility, and increased trading volume. However, we find no similar results subsequent to the auditors’ reporting on a company’s internal control over financial reporting. In our time-series intervention analyses, about 70% of sample firms have experienced significant and permanent reductions in their bid-ask spreads subsequent to the implementation of Section 302 of SOX, in contrast to only 30% of firms subsequent to the implementation of Section 404 of SOX. Our findings point to the public policy issue of whether financial reporting quality of public companies can be improved at a lower cost.
Prior studies find that analysts tend to bias their forecasts upward in poor information environments and downward in rich information environments, consistent with attempts to curry favor with management. We find that investors anticipate this behavior by reducing their response to upward forecasts in poor information environments and downward forecasts in rich information environments. Using Hugon and Muslu’s measure of analyst conservatism as an ex ante indicator of individual analysts’ forecast bias tendencies, we show that the stronger return response they find to conservative analysts’ forecast revisions is restricted to poor information environments, where optimistic analyst bias is prevalent. Our results suggest that analysts pay a price in market influence when their forecasts reinforce analysts’ typical forecast bias for the firm’s information environment. Conversely, analysts whose forecasts conflict with the typical bias for the firm are rewarded with larger than average return responses.
Prior studies in general suggest a positive association between auditor tenure (the length of an auditor–firm relationship) and reporting quality (the informational content of reported earnings). In this study, we present evidence that the association is reversed when clients represent increased litigation risks to their auditors. Featuring downward biases in reported earnings as a measure of reporting quality that stem from auditors’ minimization of costs from potential audit errors, we argue that the magnitude of such downward bias decreases in auditors’ experiences with their clients (tenure improves reporting quality). Furthermore, we predict that longer auditor tenure is associated with larger downward bias for firms with increased audit risks (tenure impairs reporting quality). Using non-operating accruals as proxy for downward bias in reported earnings, we find robust empirical evidence in support of our prediction.
We investigate whether and how the primary market values the innovations of newly public firms at their initial public offerings (IPOs) by examining the link between the size (the number of patents) and the quality (citation count) of their patent portfolios and IPO valuations. We find that the number of patents, the citation count, and innovation efficiency (IE; patents or citations scaled by research and development expenditure) are positively associated with offer price multiples but the effect of the number of patents subsumes that of the citation count/IE. There is no significant effect of patent portfolios on price revisions or first-day returns, suggesting that underwriters/firms price information on innovation quantity and quality in the offer prices and the market makes no further price adjustment on innovation information. The positive effect of innovation quantity on IPO valuation subsumes that of innovation quality. We also demonstrate that the link between patent portfolios and IPO valuations is stronger in the later sample period. Using Tobin’s Q as another IPO valuation measure produces similar results. We obtain no evidence that an IPO’s patent portfolio is overvalued in the primary market, as the number of patents and the citation count are not significantly associated with long-run stock and operating performances.
We study the relation between audit committee accounting expertise, analyst following, and market liquidity. Our main results indicate that analyst following increases subsequent to the appointment of an accounting expert to the audit committee. We also provide evidence that accrual quality, as opposed to audit quality or management earnings forecasts, is the channel through which accounting expertise increases analyst following and improves analyst forecast properties. We also show that audit committee accounting expertise is related to higher trading volume and lower liquidity risk, supporting incentives for greater analyst following. Our study extends prior literature by providing evidence that audit committee accounting expertise enhances firms’ information environment beyond the effects it has on financial reporting quality or analysts’ forecast properties. Our study also complements the literature on determinants of analyst following and market liquidity, both of which are related to cost of capital. Results from our study should be useful to firms seeking to enhance analyst following and market liquidity.
We investigate whether prior year unexpected audit fees help predict new material weaknesses in internal control over financial reporting reported under Section 404 of the Sarbanes–Oxley Act (SOX). Predicting material weaknesses may be useful to investors and other financial statement users because these disclosures have adverse economic impacts on disclosing firms. Unexpected fees are significantly associated with material weaknesses reported under Section 404, even after controlling for Section 302 disclosures and other factors associated with internal control weaknesses. Unexpected fees are associated with company-level weaknesses but are not significantly associated with account-specific weaknesses, consistent with differences in the nature and severity of the two types of material weaknesses. Our results are consistent with unexpected audit fees containing information on unobserved audit costs and client control risks, which help predict future internal control weaknesses.
The vast majority of reports written by sell-side equity analysts conclude with a reiteration of the analyst’s existing recommendation on a firm’s stock. Yet there is a disproportionate amount of research that focuses on the market reactions of changes in recommendations and a prevailing sense that reiterations do not matter. In this article, we test the hypothesis that reiterations of recommendations serve to resolve information uncertainty since the original recommendation was published and that they give rise to market reactions in the direction of the original recommendation, which we call a confirmation effect. Using a sample of analyst reports that do not contain any changes in recommendations, earnings forecasts, or price targets, we focus solely on reiterations and show that they are associated with proxies for information content, reductions in information uncertainty, and return reactions consistent with a confirmation effect.
Improved compensation disclosure should increase the efficiency of executive compensation contracts through better benchmarking with peer groups even though managers might try to influence this process through a selective choice of peers. Using a sample of Chinese companies, we find that industry benchmarking is prevalent in China. Moreover, as the regulation for executive compensation disclosure was amended in 2005, executives whose compensation is above the industry average have experienced much smaller pay rises, and executives whose compensation is below the industry average have had much higher pay raises. The results of our study are robust after controlling for various firm and industry characteristics. The results also show that companies controlled by different entities (i.e., central government, local government, or nongovernment) behave very differently in response to enhanced compensation disclosure. These findings highlight the importance of policymakers understanding how different firms react to improved disclosure.
Based on market prices and other market inputs to value assets and liabilities, adopting fair-value measurement creates many unpredictable economic consequences, such as amplifying the vicious cycle of falling prices during a worldwide financial crisis. This article investigates whether marking-to-market disclosure affects the commonality in liquidity. Commonality in liquidity is defined as the sensitivity of stock liquidity to the variation in market liquidity. My study indicates that marking-to-market disclosure is associated with higher commonality in liquidity. In addition, I find that higher commonality in liquidity is associated with lower stock liquidity. I also find that a positive association between commonality in liquidity and stock illiquidity is mitigated by the effect of a government guarantee.
We contend that mutual-fund-affiliated analysts have conflicts of interest in their role of information production. Similar to the investment-bank-affiliated analysts (Malmendier & Shanthikumar, 2014), mutual-fund-affiliated analysts are very likely to speak in two tongues, issuing optimism-biased recommendations to please their mutual fund clients due to the clients’ holdings of the stocks but less optimistic forecasts for their covered firms to provide firm-specific information for mutual funds. The net effect of these mutual-fund-affiliated analysts’ conflicting actions is not clear. We use a unique Chinese dataset that discloses the business affiliations between mutual funds and brokerage firms through commission allocations to examine whether mutual-fund-affiliated analysts produce more (or less) firm-specific information in their research compared with non-affiliated analysts. Our results indicate that mutual-fund-affiliated analysts produce more firm-specific information, manifested by lower stock price synchronicity for the firms they cover. We further find that the mutual-fund-affiliated analyst effects are more pronounced for stocks that represent significant exposure to an affiliated mutual fund’s investment, where mutual funds presumably need more firm-specific information to make investment decisions. Finally, we document that mutual-fund-affiliated analysts conduct more site visits on the stocks held by their mutual fund clients, which explains the greater information dissemination by mutual-fund-affiliated analysts.
Regulators and the public have expressed concerns about accounting firms lobbying politicians and regulators on behalf of their own audit clients because it could pose an advocacy threat to auditor independence. In this study, we examine whether these lobbying activities by accounting firms are associated with their clients’ audit quality. As required disclosures of lobbying activities under the Lobbying Disclosure Act are very limited, we construct a proxy to capture auditor lobbying on behalf of audit clients. Using our proxy for lobbying, we find that perceived audit quality (measured using earnings response coefficients) is negatively related to lobbying. However, we fail to find that actual audit quality is lower for these clients (measured as the propensity to restate earnings, propensity to issue a going-concern opinion, and discretionary accruals). Our findings suggest that investors perceive auditors’ lobbying for clients’ political interests as harmful to audit quality but that these concerns do not appear to materialize in the financial statements. Similar to the literature on other nonaudit services, our evidence suggests that reputation concerns and litigation risk provide enough incentive for auditors to maintain their independence in the presence of an advocacy threat to auditor independence.
This is an exploratory study to examine the quality or usefulness of accounting estimates of companies in China and India over time. Specifically, we examine how well the accounting estimates are able to predict future earnings and cash flows during the period 2003-2013. The results for India indicate that the out-of-sample earnings and cash flow predictions derived are more accurate and more efficient in the more recent period (2010-2013) than the earlier period (2003-2006). In contrast, the out-of-sample earnings and cash flow predictions for China are generally more biased, less accurate, and less efficient. The results indicate abnormal returns earned on hedge portfolios formed on earnings (cash flow) predictions for India in the recent period. In contrast, none of the portfolios for China earn positive returns. The results suggest that the accounting estimates in India in recent years have become better predictors of future earnings and cash flow than accounting estimates in the earlier period. However, the accounting estimates in China are not relevant for predicting earnings and cash flows over the years in the sample period.
This study examines the impact of outside directors on the association between corporate social responsibility (CSR) performance and tax aggressiveness. Based on a sample of 5,007 firm-year observations over the 2003-2009 period, we find that there is a negative association between the interaction effect of the proportion of outside directors on the board and CSR performance, and tax aggressiveness. Our additional tests confirm the reliability of our main regression results. Overall, our results indicate that the presence of outside directors on the board magnifies the negative association between CSR performance and tax aggressiveness.
Using actual practice data from U.S. corporate treasury executives, we provide initial evidence of managers’ internal estimates of their firms’ cost of equity capital (COEC) and extrapolate managers’ estimation practices to the broader population of public firms. Our study provides insights into the assumptions managers use in applying the capital asset pricing model (CAPM), the model that managers generally use to estimate their firms’ COEC according to prior research. We show that COEC estimates based on managers’ surveyed estimation practices are positively correlated with realized returns only in the pre-survey period, suggesting that managers set their COEC estimates in a backward-looking manner. Moreover, managers’ estimates are most correlated with estimates reverse-engineered following Easton, (2004) and Gode and Mohanram (2003).
Gender diversity in corporate boards and the functioning of compensation committees are two issues that have caught the attention of legislators and regulators in many countries. Using data from 5,630 observations from public companies in the United States, we find that firm and board characteristics are associated with the presence of females on the compensation committee. However, female presence on the compensation committee is not significantly associated with CEO pay (as a proportion of shareholder wealth increase). We then discuss issues related to research on gender diversity in corporate boards, and offer some suggestions for future research on diversity in corporate boards.
This article examines the determinants of allocation of decision rights between the parent company and its subsidiaries, and the economic consequence of suboptimal power structure. Based on China’s unique double disclosure for the parent company and the whole group, we construct a decentralization index to measure how decision rights are allocated within the group companies. We find a more decentralized (centralized) power structure for the groups with more uncertain (certain) external environment and with poorer (better) internal information quality. We also show that the groups with suboptimal power structure have weaker future performance.
We test for the presence of adverse selection among firms adopting the fair value option for liabilities (FVOL) embedded in Statement of Financial Accounting Standards (SFAS) 159 during the financial crisis. The FVOL is a controversial accounting choice because it allows firms to increase earnings when credit quality deteriorates. We find that firms with higher credit risk, lower profitability, and negative abnormal stock returns are more likely to adopt the FVOL, and that these firms exhibit negative abnormal stock returns over 1- to 3-year horizons after adoption. We conclude that adverse selection occurs among adopters. Although these findings suggest that the FVOL reduces comparability and information transparency, they also imply that accounting choice can be a valuable tool for standard setting because it can induce firms to reveal their type.
Based on a quadratic form of audit tenure in explaining audit quality, we estimate a reference point that is potentially optimal for audit firm rotation for 22 countries across legal regimes with high versus low levels of investor protection. We find that our estimate for the high investor protection regime is longer than that for the low investor protection regime (24 years vs. 14 years for our main measure). However, very few firms from our sample would have been affected if there were a requirement of a mandatory rotation term, suggesting that mandatory audit firm rotation may not be necessary. In additional analyses, we not only evaluate the empirical validity of the quadratic form but also use various measures of our key variables, to conduct several other robustness tests. We continue to find a longer optimal point for countries with stronger investor protection in these robustness tests. Our findings imply that stronger country-level investor protection is a substitute for a shorter term of mandatory audit firm rotation.
Biased evaluation of evidence exists when an auditor either over-emphasizes evidence that supports management assertions or over-emphasizes evidence against management assertions. This study examines if an auditor’s advocacy attitudes lead to bias in information search for audit evidence. We measure the range of advocacy attitudes of individual auditors and hypothesize that auditors at either end of the advocacy spectrum may impede the objectivity of evidence gathered. Results from 60 Big 4 auditors indicate that advocacy attitudes affect both initial judgments and consequent search strategies of auditors. When initial judgments are client-favorable, all auditors exhibit search strategies focused on finding evidence to take a more conservative position; however, when initial judgments represent an unfavorable client position, auditors with lower advocacy attitudes exhibit a stronger tendency to search for additional evidence against a client-favorable position, consistent with a confirmation bias. Conversely, auditors with more neutral attitudes plan a more objective search effectively mitigating the bias. Aggregate findings establish an important link between bias and information search that may manifest itself in auditor training procedures and be of interest to auditing regulators.
Closed-end country funds are interesting in that they have two sets of prices for the same underlying assets—the net asset value (NAV) of the fund holdings as measured using the underlying firms’ stock prices in their home markets and the fund price at which the fund trades on a U.S. stock exchange. Utilizing the theoretical framework of information asymmetry in two separate markets for an identical asset, we find that the difference between the fund’s NAV and its trading price (i.e., the fund discount) is positively associated with the earnings opacity of the underlying companies. Such a positive association is consistent with the notion that U.S. investors face higher information acquisition and processing costs when compared with local investors, and therefore earnings opacity exacerbates the information disadvantage of U.S. investors, leading to a larger fund discount. We further show that the positive relation varies predictably with U.S. investors’ information acquisition and processing costs and with the extent to which host stock markets are segmented from the U.S. market. Specifically, we find that the positive relation between earnings opacity and fund discounts is weaker for those funds with more U.S. cross-listings in fund holdings, with underlying companies following financial reporting standards similar to U.S. standards, and with less segmented local markets.
We examine the relationship between residual audit fees and the ability to predict future earnings. Recent research suggests that residual audit fees contain information about accounting quality. However, residual audit fees could either represent high accounting quality or a risk premium for low accounting quality. We extend this literature by providing evidence that residual audit fees are indicative of a lower quality information environment which has a negative impact on investors’ ability to anticipate future earnings. Specifically, we first show that residual audit fees are negatively associated with the ability of current earnings to predict future earnings. Furthermore, residual audit fees are negatively associated with analyst forecast accuracy and positively associated with the dispersion in analyst forecasts. Overall, our results are consistent with the notion that residual audit fees are indicative of poor earnings quality, and that this lower quality manifests itself in a lower quality information environment for investors and analysts.
We examine differential volume–price reactions to loss announcements and their association with loss reversals. Our findings show that differential volume–price reactions are dissimilar between firms reporting profits and losses. In addition, the differential volume–price reactions surrounding loss announcements are useful in predicting loss reversals. When jointly considered, volume and price reactions provide unique information about future profitability for firms currently reporting losses. Overall, our results are consistent with losses generating more investor disagreements and more trading volume and show that a measure based on differential volume–price reactions to loss announcements is informative with regard to predicting subsequent loss reversals.
The Sarbanes–Oxley Act emphasizes auditor and analyst independence as defining characteristics of quality financial reporting. We argue that this focus on independence may have adverse effects on auditor expertise. In particular, an independent auditor will lack firsthand knowledge regarding the construction of a client’s financial statements, knowledge that is obtained through the provision of a variety of non-audit services. This lack of firm-specific expertise introduces the potential for a bias analogous to that alleged in sports fans’ belief in the "hot hand" in athletic performance. In studies of professional sports, little evidence of serially abnormal performance has been documented by empirical researchers. As a result, many assert the absence of a hot hand in sports and conclude that athletic spectators’ beliefs and assertions thereof are not rational. We demonstrate that commonly used tests lack power specifically in the detection of abnormally elevated streaks in performance, even for large sample sizes. Importantly, in contrast to the usual non-structural (and non-parametric) approach, incorporating a structural-data-generating process dramatically enhances an observer’s ability to make the correct inference concerning the existence of a hot hand even if only a few observations are available. Of relevance to the debate regarding the (dis)advantages of independent auditors, we argue that auditor expertise regarding the underlying structure of the data-generating processes is paramount in increasing statistical power in (a) an auditor’s detection of anomalous corporate behavior and (b) inquiries by the Public Company Accounting Oversight Board (PCAOB) regarding auditor inference and potential corruption.
We study the organizational impact of internal control systems, by examining 1,593 firms with 15,606 executives over 2002-2010. We find that internal control systems explain a significant amount of executive and, in particular, CFO compensation, after controlling for other governance, executive personal characteristics, firm, and macroeconomic determinants of pay. Moreover, the negative relationship between pay and internal control systems suggests that executives operating in firms with ineffective internal control systems earn greater compensation. The results of the longitudinal analysis suggest that firms with ineffective internal control systems have greater agency problems and, consequently, greater levels of executive compensation. The CEO pay shows a nonsignificant relationship with internal control systems.
This study analyzes the impact of Information Technology (IT) Controls quality on control risk and audit fees. The impact is expected to occur when regulation increases sensitiveness to audit risk assessment. The research focuses on IT Controls as part of Internal Control over Financial Reporting, particularly on scoping quality, segregation of duties, and Controls framework compliance. The research was conducted with a questionnaire on a population of Italian listed companies. We find that audit fees are lower for higher IT scoping quality, IT Controls segregation of duties, and IT Controls framework compliance. The overall conclusion is that IT Controls quality is related to lower control risk, audit fees, and audit effort.
Models of financial economists including Karpoff, Varian, Holthausen and Verrecchia, and Dontoh and Ronen have demonstrated that there are three distinct fundamental determinants of trading volume reaction to new information releases: first, the extent of differences in investors’ prior beliefs; second, differences in their interpretations of the information; and third, the level of consensus that the information release induces among them. Although these effects are well understood theoretically, empirical studies that investigate trading volume reaction to the arrival of new information have tended to combine these three fundamental determinants, thereby masking their distinct incremental effects on trade. In this article, we examine all three potential sources of trade in response to information: heterogeneous prior beliefs, differential interpretation, and the consensus effect of the news. We find that all three of these effects have a distinct incremental impact on trading volume, thereby corroborating the theoretical models of financial economists.
We apply voting theory to the context of audit committees and examine how the even–odd nature of audit committees is related to earnings quality. We hypothesize that an audit committee with an odd number of directors can improve the committee’s voting efficiency by better aggregating directors’ information and thus enhance the quality of committee decisions, as compared with an audit committee with an even number of directors. Supporting this implication, we find that an odd audit committee is associated with lower likelihood of financial restatements than an even audit committee, and that this relation is stronger when the committee members have more heterogeneous opinions, hold less equity ownership, are in a smaller audit committee, and face a more entrenched management.
We empirically compare the reliability of the dividend (DIV) model, the residual income valuation (CT, GLS) model, and the abnormal earnings growth (OJ) model. We find that valuation estimates from the OJ model are generally more reliable than those from the other three models, because the residual income valuation model anchored by book value gets off to a poor start when compared with the OJ model led by capitalized next-year earnings. We adopt a 34-year sample covering from 1985 to 2013 to compare the reliability of valuation estimates via their means of absolute pricing errors (MAPE) and corresponding t statistics. We further use the switching regression of Barrios and Blanco to show that the average probability of OJ valuation estimates is greater in explaining stock prices than the DIV, CT, and GLS models. In addition, our finding that the OJ model yields more reliable estimates is robust to analysts-based and model-based earnings measures.
We examine auditor business risk by analyzing the relation between excess cash holdings and auditor pricing behavior. Prior research links excess cash holdings to risks associated with manager opportunism and external monitoring. Our analyses provide evidence of a positive relationship between excess cash and audit fees. The economic magnitude of the increase in total audit fees due to an increase in excess cash holdings is approximately 5% greater for firms in the top quartile of excess cash holdings versus those in the bottom quartile. We also find that the strength of shareholder rights reduces the positive relationship between excess cash and audit fees, and excess cash holdings are assigned lower audit fees among firms that follow an investment-intensive strategy than those that tend to hold on to their cash. Our article contributes to the literature by examining auditor pricing of excess cash holdings, including factors that affect auditors’ risk perceptions, and ultimately provides unique insights into how auditors view agency conflicts indicated by excess cash holdings.
We examine the relative efficiency of whisperers’ and analysts’ forecasts of one-quarter-ahead earnings per share (EPS) and identify commonalities and differences in their use of fundamentals to forecast earnings. Results suggest that (a) fundamentals that focus on sales and cost of sales are relevant in explaining one-quarter-ahead EPS changes; (b) whisperers focus on cash flow fundamentals and accrual-based earnings measures in their one-quarter-ahead forecasts, whereas analysts focus on only cash flow fundamentals; and (c) although neither analysts nor whisperers fully incorporate information contained in fundamentals and accrual-based earnings measures in their forecasts, whisperers’ earnings forecast model (forecast errors model) exhibits higher (lower) explanatory power than that of analysts. We also examine robustness of our results by reestimating the models using a two-way random-effects panel data estimator. Although our conclusions remain the same, more statistically significant fundamentals emerge in panel regression results. Evidence presented in this article is consistent with (a) whisperers being different from analysts and (b) whisper forecasts containing unique incremental information beyond that of analysts’ forecasts. Market participants may want to consider using both forecasts when making investment decisions.
We investigate whether auditors take into account accruals quality, a proxy for the cash flow risk associated with earnings, by adjusting audit hours and audit fees. Accruals quality tells investors about the mapping of accounting earnings into cash flows. Poor accruals quality weakens this mapping and thus increases this cash flow risk. We find a negative relationship between accruals quality and audit hours/fees, indicating that auditors increase their audit efforts by modifying audit procedures and substantive tests and charge higher fees for the increased cash flow risk. In addition, we find that both innate accruals quality and discretionary accruals quality are negatively related to audit hours and fees but that innate accruals quality is more likely to influence audit hours and fees than discretionary accruals quality. The results indicate that auditors incorporate the cash flow risk associated with accruals quality but that their response varies according to the source of accruals quality.
This article is the first to examine financial restatements by real estate investment trusts (REITs). We provide a descriptive breakdown of the underlying causes of REIT restatements as well as overall and subsample analyses of stock market reactions to restatements from 2000 to 2011. REIT restatements occur for a large variety of accounting issues with the most common being expense-related (e.g., leases, depreciation). We find that the average market reaction for REIT restatements is negative 0.63%, which is less negative than non-REIT restatements. Further investigation reveals that a significant portion of REIT restatements result in large positive or negative returns, the most extreme of which appear to be a result of both the restatement and other news released simultaneously. Cross-sectional analysis shows that the most important determinant of restatement cumulative abnormal returns (CARs) is whether the restatement is a result of Securities and Exchange Commission (SEC) comment letters or involves an investigation by regulators, which lowers the CAR by 5.64%. Overall, the findings suggest that REIT restatements occur for a variety of reasons, and REIT investors place high value on quality financial statements.
Using a sample of industry-diverse nonprofit organizations, we find support for stakeholders’ use of nonprofit going-concern audit opinion (GCO) reports. We study the reactions of the three largest nonprofit stakeholder groups: donors, service recipients, and managers. Our findings suggest that although large (sophisticated) donors respond negatively to a GCO, small (unsophisticated) donors contribute more following a GCO. We also find that service recipients spend more at service-oriented organizations than at charitable nonprofits following a GCO. Finally, managers respond to a GCO by increasing organizational efficiency at service-oriented organizations. Taken together, the evidence suggests that GCOs are informative in the nonprofit sector, and stakeholders’ responses to GCOs depend on stakeholder and organization type.
This article examines the role of internal control requirements under the Sarbanes–Oxley (SOX) Act of 2002 in firms’ cost of raising equity capital. We find that, prior to the disclosure of internal control weaknesses (ICWs), ICWs are not directly associated with underwriters’ gross spread and seasoned equity offering (SEO) underpricing. After the disclosure, however, underwriters charge a risk premium on ICW issuers, especially on those disclosing ICWs in multiple consecutive years. We also find that SEO underpricing is exacerbated by multiple-year-disclosed ICWs but not by first-timers. More notably, we find that managers play a dominant role in deciding issue size pre-disclosure, but this dominance weakens post-disclosure. Taken together, our evidence suggests that internal controls help moderate the cost of raising equity capital and that ICW disclosures have significant implications for underwriters in the equity issue market.
This article examines how legal regime may affect the market’s reaction to the auditor’s going-concern (GC) opinion. We hypothesize that, ceteris paribus, investors in a creditor-friendly bankruptcy regime (the United Kingdom) will react more adversely to a first-time GC opinion indicating increased risk of loss associated with bankruptcy than do investors in a debtor-friendly bankruptcy regime (the United States). Our empirical results are consistent with this expectation. These findings are strengthened by additional analysis of the impact of the recent convergence in bankruptcy regime between the United States and United Kingdom on the market reaction to GC opinions in the United States. Our findings demonstrate a specific situation where the auditing standards and institutional factors interact, with their joint impact affecting the market’s reaction to the GC opinion.
The frequency of non-GAAP (or "pro forma") reporting has continued to increase in the United States over the last decade, despite preliminary evidence that regulatory intervention led to a decline in non-GAAP disclosures. In particular, the Sarbanes–Oxley Act of 2002 (SOX) and Regulation G (2003) impose strict requirements related to the reporting of non-GAAP numbers. More recently, the Securities and Exchange Commission (SEC) has renewed its emphasis on non-GAAP reporting and declared it a "fraud risk factor." Given the SEC’s renewed emphasis on non-GAAP disclosures, we explore the extent to which regulation has curbed potentially misleading disclosures by investigating two measures of aggressive non-GAAP reporting. Consistent with the intent of Congress and the SEC, we find some evidence that managers report adjusted earnings metrics more cautiously in the post-SOX regulatory environment. Specifically, the results suggest that firms reporting non-GAAP earnings in the post-SOX period are less likely to (a) exclude recurring items incremental to those excluded by analysts and (b) use non-GAAP exclusions to meet strategic earnings targets on a non-GAAP basis that they miss based on Institutional Brokers’ Estimate System (I/B/E/S) actual earnings. However, we also find that some firms exclude specific recurring items aggressively. Overall, the results suggest that while regulation has generally reduced aggressive non-GAAP reporting, some firms continue to disclose non-GAAP earnings numbers that could be misleading in the post-SOX regulatory environment.
Prior research documents significant negative long-term stock returns following bond-rating downgrades. Some downgraded firms are placed on credit watches before downgrades, and we find that the post-downgrade stock underperformance of such firms is significantly reduced. We explore two explanations for the difference in post-downgrade stock performance that are not mutually exclusive: (a) a credit watch placement provides an early signal of the subsequent rating downgrade and gives investors more time to better understand the information content of the downgrade (the early-disclosure effect), and (b) a credit watch placement induces better recovery from credit deterioration for the downgraded firm in the long run (the recovery effect). We find that firms receiving watch-preceded downgrades show better improvements in operating profitability, financial leverage, and overall default risk, and are less likely to be further downgraded in future periods, compared with firms that are directly downgraded. Our findings suggest that the recovery effect is important in explaining downgraded firms’ performance in the long run and provide new evidence in support of the premise in the recent literature that credit watches can induce on-watch firms’ efforts to restore deteriorated credit quality.
The recent movement in standards setting toward fair-value-based accounting beyond financial assets and liabilities calls for more empirical evidence on fair-value measurement, especially that of intangible assets. This article studies the initial valuation of goodwill and identifiable intangible assets after acquisitions. We find that the allocation of purchase price to goodwill and identifiable intangible assets is related to the economic determinants of the valuation. However, it is also significantly affected by managerial incentives arising from the differential treatments of goodwill and identifiable intangible assets under Statement of Financial Accounting Standards (SFAS) 142. The same managerial discretions are not exhibited in the purchase price allocation prior to SFAS 142, when goodwill and other intangibles are both amortized. These findings suggest that unverifiable fair value measures are associated with the underlying economics but also deviate from the true values in the presence of management reporting incentives. Further analysis suggests that external appraisers constrain managerial discretion in intangible asset valuation to an extent but do not completely eliminate it.
This study examines the impact of CEO inside debt on earnings management. Theory predicts that CEOs with higher inside debt holdings adopt less risky corporate policies and choose investment policies that result in less volatile earnings. Under such circumstances, CEOs would face weaker demand for income smoothing. Consistent with these expectations, our results reveal that CEO inside debt is negatively associated with both accrual- and real activities-based earnings management. We also find that firms with higher levels of CEO inside debt are less likely to meet or slightly beat analysts’ earnings forecasts. Furthermore, the capital market response to positive earnings surprises is greater when CEOs hold higher positions of inside debt. Overall, our findings suggest that inside debt counteracts CEOs’ incentives to smooth earnings through earnings management and investors understand the deterrence effect of inside debt on earnings management.
This study demonstrates that the firms that switch from Big N auditors to non-Big N auditors use less accounting conservatism in the post-switch year relative to the year before switch. Our analyses further show that the decline in conservatism is mainly evident for the firms that switch to smaller non-Big N auditors, but not when the firms switch from Big N to second-tier national auditors, such as BDO Seidman and Grant Thornton (BDO/GT). In addition, we find that the firms experiencing switches from Big N to smaller non-Big N firms exhibit less accounting conservatism in the post-switch year when they have relatively weaker corporate governance. We also observe that both auditor resignation and auditor dismissal events lead to a significant decline in post-switch conservatism, especially among the firms with weaker governance mechanisms that experience switch to smaller non-Big N auditors. Furthermore, the smaller and younger firms with weaker governance adopt less conservatism in the post-switch period relative to the pre-switch period. Our findings complement prior research in this area and have policy implications that the quality of audits provided by smaller auditors may continue to remain a matter of concern in the post–Sarbanes–Oxley Act of 2002 (SOX) and post–Public Company Accounting Oversight Board (PCAOB) periods, especially when the firms have weaker governance.
Previous research shows that accounting conservatism facilitates debt contracting. Extending this line of literature, we examine whether the role of accounting conservatism in accessing external debt to attain firm growth varies with its maturity. We find evidence of a positive relationship between conservatism and debt maturity. We also observe a positive relationship between conservative accounting and future growth funded by all classes of debt, but this relation is due to long-term rather than short-term debt, which is less prone to agency risk. Furthermore, the associations between conservatism and debt maturity and conservatism and growth financed by long-term debt are mostly observed for firms with fewer anti-takeover provisions in place. These findings suggest that the demand for accounting conservatism is not uniform across different debt maturity horizons.
We document in this study that lack of soft information as a result of longer distance between the firm and rating agency headquarters leads to higher errors in bond ratings, reflected by Type I and Type II errors for missed defaults and false warnings, respectively. Our results show that for each 100 km in terms of the distance between a firm’s and the rating agency headquarters, the likelihood of missed defaults (Type I error) increases by 4.9% and false warnings (Type II error) increases by 2.1%. In addition, our analyses show that the downgrades are less timely for firms that are further away from the rating agency headquarters. The results also show that missed defaults are especially higher, and timeliness of downgrades is lower for firms with higher complexity, lower analyst following, and lower accessibility to the rating agency headquarters. Although analysts adjust their ratings lower when soft information is lacking as a result of longer distance, their adjustments do not fully compensate for the lack of soft information.
We take advantage of China’s relationship-based institutional setting to investigate whether and how firms’ disclosure decision is affected by political patronage and associated political costs considerations. Using a sample of 65 firms involved in the Shanghai Pension corruption scandal of 2006, we find that relative to benchmark firms, the connected firms are associated with lower levels of disclosure prior to the scandal. However, they significantly increased their disclosures in the year immediately following the public exposure of the scandal. A content analysis indicates that the increased disclosures are value-relevant, and are not merely used as a public relations effort to subdue public outcry in the immediate aftermath of the scandal. Cross-sectional analyses further reveal that the increase in disclosure is positively associated with the extent of firm’s guanxi dependence and type/severity of involvement in the scandal. We conclude that the increased disclosures are in response to the heightened risk and potential costs of regulatory and public scrutiny in the wake of a major event involving high political and public sensitivity. The evidence is supportive of the political costs hypothesis, and has important managerial and policy implications.
This study examines the relationship among analysts’ earnings forecast revisions, information uncertainty, and stock returns and provides new evidence that stock price drift occurs after analysts’ earnings forecast revisions. Using data from the Australian stock market over the period of 1992 to 2009, we find that the stocks with upward earnings revisions experience positive returns, while stocks with downward revisions have negative returns. The effect is more prominent in stocks with high information uncertainty. The results are robust after controlling for market conditions, seasonality, and risks. Our evidence supports the conservatism bias model that investors tend to underweight the public information, such as analysts’ earnings forecast revisions. Importantly, our evidence provides possible explanations about the violation of the efficient market hypothesis. Our results suggest that the conservative bias causes investors not to sufficiently update their beliefs and eventually results in subsequent return continuation as investors’ underreaction to analysts’ earnings forecast revision is stronger with higher information uncertainty.
The globalization of audit markets not only provides an opportunity for the U.S. Big 4 auditors to establish international expertise through global networks, but it also exposes them to reputation risk arising from the acts of their local partners. We analyze the audit failure of ChuoAoyama, one of the Japanese Big 4 audit firms, and find that its credibility impairment reduced security prices of not only the clients of PricewaterhouseCoopers (PwC), their U.S. affiliate, but also the American clients of all other Big 4 auditors affiliated with the Japanese Big 4. Because the quality of the U.S. audit firms is perceived as superior to that of auditors in other countries, we also analyze the premiums arising from the affiliation with the U.S.-led global audit firm networks. We compare the effect of Andersen’s audit failure with ChuoAoyama’s in Japanese capital markets and find that the magnitude of negative market reactions is larger for Andersen’s failure than for ChuoAoyama’s. Together, these results suggest that global audit firm networks have created a network-wide reputation for their services that is susceptible not only to audit failures of the U.S. Big 4 but also to those of non-U.S. affiliates and that there is a quality premium for the U.S. Big 4 in Japanese markets. Our results provide a rational explanation for PwC’s aggressive efforts to temper the negative impact of ChuoAoyama’s failure on their reputation.
The licensing of intellectual property (IP) is growing dramatically. A distinguishing feature of licensing versus standard sales is that license contracts often involve self-reporting; the licensor relies on the licensee to report the royalties owed. This study examines self-reporting licensing contracts using a game-theoretic approach to royalty compliance. A licensee’s accounting system generates a potentially inaccurate royalty report provided to the licensor. This self-reporting gives rise to demand for auditing by the licensor. We characterize the optimal royalty contract, accounting system choice by the licensee, and audit strategy choice by the licensor. We find that self-reporting either (a) limits the licensee’s rents, but lowers social welfare, or (b) enhances social welfare by facilitating use of the IP by the low-cost licensee instead of the high-cost licensor. As accounting system costs decrease or the gains from outsourcing increase, variable royalties based on self-reporting become even more desirable.