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The Timeliness of Earnings News and Litigation Risk
Dain Donelson (UT), John McInnis (UT), Richard Mergenthaler (Iowa), and Yong Yu (UT)
The Accounting Review (conditionally accepted)(AAA)
Take-away:By revealing bad earnings news on a timely basis, managers can significantly reduce the chance of securities litigation. Earlier studies suggested that bad earnings “warnings” actually triggered lawsuits, but we use a new research approach and find that timely disclosure clearly reduces the threat of litigation.
Abstract:This study investigates whether the timely revelation of bad earnings news is associated with a lower incidence of litigation. The timeliness of earnings news is captured by a new measure based on the evolution of the consensus analyst earnings forecast. Holding total bad earnings news and other determinants of litigation constant, we find that earlier revelation of bad earnings news lowers the likelihood of litigation. This result holds for both settled and dismissed lawsuits. Further, we reconcile our findings with prior work that measures timeliness using managerial warnings via press releases. These tests suggest our findings are attributable to the ability of our timeliness measure to capture bad earning news revealed through disclosure channels beyond press releases.
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Managerial Reporting, Overoptimism, and Litigation Risk
Volker Laux and Phillip Stocken
Journal of Accounting and Economics(JAE)
Take-away:We show that a heightened threat of litigation can increase incentives for managerial misreporting.
Abstract:We examine how the threat of litigation affects an entrepreneur’s reporting behavior when the entrepreneur (i) can misrepresent his privately observed information, (ii) pays legal damages out of his own pocket, and (iii) is optimistic about the firm’s prospects relative to investors. We find higher expected legal penalties imposed on the culpable entrepreneur do not always cause the entrepreneur to be more cautious but instead can increase misreporting. We highlight how this relation depends crucially on the extent of entrepreneurial overoptimism, legal frictions, and the internal control environment.
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Perceived Auditor Independence and Audit Litigation: The Role of Nonaudit Services Fees
Jaime Schmidt
The Accounting Review(AAA)
Take-away:The study provides evidence that auditor fees (and in particular, non-audit service fees) play a role in the initiation and resolution of auditor litigation following a restatement.
Abstract:This study investigates whether audit litigants act as if they believe jurors will associate auditor-provided nonaudit services (NAS) with impaired auditor independence, and thus substandard auditor performance. Using GAAP-based financial statement restatements disclosed from 2001 – 2007 as an indicator for audit failure, I find that the amount of nonaudit (NAS) fees and the ratio of NAS fees to total fees is positively associated with the likelihood that a restatement results in audit litigation. I also find that when plaintiff attorneys argue that auditor independence was impaired due to dependence on client fees and, in particular, NAS fees, restatement-related audit litigation is more likely to result in an auditor settlement and a larger amount of settlement. These results suggest that audit litigants act as if they believe NAS fees will strengthen the case against the auditor, and thus affect the court resolution if the lawsuit is taken to verdict.
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Stock option vesting conditions, CEO turnover, and myopic investment
Volker Laux
Journal of Financial Economics(JFE)
Take-away:This paper shows that the optimal design of stock option vesting conditions in executive compensation is more subtle than conventional views suggest. For example, it shows that long vesting periods can backfire and induce myopic investment behavior.
Abstract:Corporations have been criticized for providing executives with excessive incentives to focus on short-term performance. This paper shows that investment in short-term projects has beneficial effects in that it provides early feedback about CEO talent, which leads to more efficient CEO replacement decisions. Due to the threat of CEO turnover, the optimal design of stock option vesting conditions in executive compensation is more subtle than conventional views suggest. For example, I show that long vesting periods can backfire and induce excessive short-term investments. The study generates new empirical predictions regarding the determinants and impacts of stock option vesting terms in optimal contracting.
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The Extent of Implicit Taxes at the Corporate Level and the Effect of TRA86
By Ross Jennings, Connie D. Weaver and William J. Mayew
Contemporary Accounting Research(CAR)
Take-away:When Congress passes a tax break like a credit for buying equipment, competitive forces may shift that explicit benefit to other parties, like the supplier in the form of higher prices, employees in the form of higher wages, or customers in the form of lower prices. Prior to the landmark Tax Reform Act of 1986, the benefits of nearly all tax preferences for corporations were shifted to others, but after TRA86, we find that corporations retain about two-thirds of the benefits. Thus, after TRA86, explicit tax preferences increase the after-tax income of the corporations receiving the preferences.
Abstract:We examine the extent of implicit taxes at the corporate level and the effect on implicit taxes of the Tax Reform Act of 1986 (TRA86) in the United States. Using a variety of specifications, we find consistent evidence that implicit taxes eliminate virtually all of the cross-sectional differences in explicit tax preferences prior to TRA86, and then abruptly decline and eliminate only about one-third of the cross-sectional differences in tax preferences in years following TRA86. We triangulate this evidence that implicit taxes declined following TRA86 by also providing evidence (a) of a decline in the relation between changes in tax preferences and changes in pre-tax returns, (b) of an increase in the persistence of tax-related earnings changes, (c) that these dramatic economic changes are priced by investors. Finally, we provide evidence suggesting that the decline in implicit taxes after TRA86 is driven at least in part by expansion of aggressive tax planning and use of tax shelters. Taken together these results indicate that TRA86 had a profound and lasting effect on implicit taxes at the corporate level.
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A Post-SOX Examination of Factors Associated with the Size of Internal Audit Functions
By Urton L. Anderson, Margaret H. Christ, Karla M. Johnstone, and Larry Rittenberg
Accounting Horizons(AAA)
Take-away:This paper develops and test a model that can be used to assists internal audit directors and audit committees in answering the question of how much of the organization’s resources should be dedicated to the internal audit function.
Abstract:This study develops and tests a conceptual model articulating factors associated with internal audit function size in the post-SOX era. These factors include audit committee characteristics, internal audit characteristics and mission, internal audit activities performed by others (including outsourced providers and other divisions within the organization), and organization characteristics. Results of a survey of 173 public and private companies reveal that internal audit function size is positively associated with: (1) better audit committee governance, (2) greater organizational experience of the chief audit executive, (3) missions involving IT auditing, (4) the use of sophisticated audit technologies, (5) the use of a staffing model in which internal audit is used for rotational leadership development, (6) organization size, and (7) the number of foreign subsidiaries that the organization possesses. Further, internal audit function size is inversely associated with: (1) the percentage of internal audit employees that are Certified Internal Auditors, and (2) the extent of assurance and compliance activities outsourced to outsiders. These results contribute to prior literature on internal audit function size by considering a variety of factors that are associated with internal audit function size in the contemporary era.
- “Do financial analysts’ long-term growth forecasts matter? Evidence from stock recommendations and career outcomes”
By Boochun Jung, Philip B. Shane, and Sunny Yanhua Yang
Journal of Accounting and Economics (JAE) forthcoming.
Take-away: Not all analysts forecast or publish their long-term growth forecasts. Those that choose to publish their long-term forecasts issue more valuable recommendations and have more favorable career outcomes.
Abstract: Prior literature portrays long-term growth (LTG) forecasts as nonsensical from a valuation perspective. Instead, we hypothesize that LTG forecasts signal high effort and ability to analyze firms’ long-term prospects. We document stronger market response to stock recommendation revisions of analysts who publish accompanying LTG forecasts. We also hypothesize and find that these analysts are less likely to leave the profession or move to smaller brokerage houses. Consistent with Reg. FD’s intention to promote fundamental analysis of long-term earnings prospects, post-Reg. FD observations drive our results. Overall, we identify previously undocumented benefits accruing to analysts who publish LTG forecasts.
- “Discontinuities and Earnings Management: Evidence from Restatements Related to Securities Litigation”
Dain Donelson, John McInnis and Richard Mergenthaler.
Contemporary Accounting Research (CAR), forthcoming.
Takeaway: A disproportionate number of firms appear to just avoid losses, earnings declines, and missing analyst forecasts. While many academics attribute these findings to pervasive earnings management, others disagree. Our analysis of firms known to have manipulated earnings supports the earnings management explanation.
Abstract: A heated debate exists as to whether discontinuities in earnings distributions are indicative of earnings management. While many studies attribute discontinuities in earnings distributions to earnings management, other studies argue that earnings discontinuities are artifacts of sample selection and research design. Overall, there is limited direct evidence of a connection between earnings discontinuities and earnings management. In this study, we provide direct evidence linking earnings management to earnings discontinuities for a sample of firms that settle securities class action lawsuits and restate earnings from the alleged GAAP violation period. We compare the distribution of restated (“unmanaged”) earnings to originally reported (“managed”) earnings. We find that discontinuities are not present in the distribution of analyst forecast errors and earnings changes using unmanaged earnings but are present using managed earnings. The discontinuity in the earnings level distribution is attenuated, but not eliminated, on an unmanaged basis. These shifts among our sample of firms are caused by earnings management and cannot be explained by sample selection or research design issues. Our findings are important because we provide the first evidence of a link between intentional manipulations of earnings and discontinuities in earnings distributions. Overall, our evidence supports the use of earnings discontinuities as an indicator of earnings management.
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“Rules-Based Accounting Standards and Litigation”
Dain Donelson, John McInnis and Richard Mergenthaler,
The Accounting Review(TAR) conditionally accepted.
Takeaway:Prof McInnis finds lawsuits are more common when firms restate accounts subject to principles-based standards.
Abstract : Some claim that rules-based accounting standards shield firms from litigation, while others argue that violations of detailed rules give plaintiffs a “roadmap” to successful litigation. We inform this debate by investigating whether rules-based standards are associated with the incidence and outcome of securities class action litigation. Overall, our results suggest that rules-based standards are associated with a lower threat of litigation. These results are of interest in the debate regarding the switch from a more rules-based U.S. GAAP to a more principles-based IFRS.
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"Do Financial Statement Users Assess Relevance Based on Properties of Reliability?"
Kathryn Kadous, Lisa Koonce and Jane Thayer
The Accounting Review(TAR) forthcoming
Takeaway: Prof Koonce discovers financial statement users judge information as relevant only when it is reliable.
Abstract: We conduct multiple experiments, set within the fair value context, to show that financial statement users do not view relevance and reliability as independent constructs. Instead, users’ assessments of the relevance of fair value are influenced by variations in properties that are associated with the reliability of its measurement. The relationship between assessed relevance and assessed reliability is unidirectional, in that factors underlying reliability influence judgments of relevance, but factors underlying relevance do not influence judgments of reliability. Our findings are important because many criticisms against the relevance of fair value may be attributable to users confusing relevance and reliability.