The faculty and doctoral students publish regularly in some of the top academic journals around the globe. With each publication they show their commitment to expanding the knowledge of the accounting community as a whole. Making great strides in accounting research has helped keep this department number one.
Click arrow for abstract
Example-Based Reasoning and Fact-Weighting Guidance in Accounting Standards
Gregory Paul Capps (Independent), Lisa Koonce (UT) and Brian J. White (UT)
Contemporary Accounting Research (forthcoming)
The provision of examples as implementation guidance is pervasive in accounting standards. Prior research has established that preparers engage in “example-based reasoning,” a tendency to favor the accounting treatment in an example, even when the example does not exactly match the transaction at hand. In this paper, we investigate whether fact-weighting guidance counteracts this tendency. Such guidance, now found in some accounting standards, indicates whether particular transaction facts are more important than others in determining the appropriate accounting treatment. Using an experiment, we find that fact-weighting guidance does reduce preparers’ tendency to favor the accounting treatment in an example. However, results also suggest that some degree of example-based reasoning persists even with fact-weighting guidance, and that preparers are not fully aware of how fact-weighting guidance affects their judgments. Our findings have practical implications. They suggest to standard setters a potential remedy — namely, fact-weighting guidance — for the misuse of accounting examples. They also provide insights to accounting preparers regarding how fact-weighting guidance influences their judgments in ways they may not anticipate.
The Accuracy of Disclosures for Complex Estimates: Evidence from Reported Stock Option Fair Values
Brian Bratten (Kentucky), Ross Jennings (UT), and Casey Schwab (Georgia)
Accounting, Organizations and Society (forthcoming)
We provide evidence that employee stock option footnote disclosures for as many as twenty percent of a large sample of public companies (a) are not internally consistent, and (b) the inconsistencies are likely due to unintentional errors that were not detected by their auditor. We also provide evidence that these errors make it more difficult for financial statement users, including sophisticated analysts, to forecast the stock option expense component of net income.
In this study, we exploit the unique reporting requirements for employee stock options to provide large sample evidence on the accuracy of footnote disclosures related to a specific complex estimate, the fair value of options granted. We first document the frequency and magnitude of differences between (1) the reported weighted-average fair value of options granted and (2) the calculated option fair value using the disclosed weighted-average valuation model inputs and the Black-Scholes option pricing model. In a sample of 23,358 firm-year observations between 2004 and 2011, we find that 23.9 percent have reported and calculated option fair values that differ by more than ten percent, and that these differences are sticky and are frequently significant as a percentage of net income. We also find that fair value differences are larger for firms that (1) exhibit anomalous stock option footnote disclosures that likely result from disclosure errors, (2) have more complex and hence error-prone stock option programs, and (3) have lower quality financial reporting. Taken together this evidence is consistent with large fair value differences that are primarily due to unintentional errors in the stock option footnote disclosures. To document the consequences of these fair value differences, we provide evidence that errors in the reported fair values prevent financial statement users from using the reported values to reliably estimate future stock option expense for many firms. Consistent with this result, we also find that analyst forecasts are less accurate and more disperse for firms with larger fair value differences.
Natural Optimism in Financial Reporting: A State of Mind
Gregory Paul Capps (Independent), Lisa Koonce (UT) and Kathy R. Petroni (Michigan)
Accounting Horizons (forthcoming)
The objective of this paper is to cohesively introduce the notion of natural optimism into the accounting literature and to provide insights into the role of natural optimism in financial reporting on the part of firm managers. To accomplish this, we first discuss the research that demonstrates that optimism is the natural state of mind for most people and therefore we believe that firm managers involved in preparing financial statements are likely to exhibit naturally occurring optimism. Second, we identify where natural optimistic reporting is most likely to occur in financial reporting. Third, we address the challenges involved with mitigating or eliminating natural optimism in financial reporting. Finally, we address the relationship between optimism and overconfidence because these two concepts are often used interchangeably in the accounting literature despite their conceptual differences.
A New Measure of Disclosure Quality: The Level of Disaggregation of Accounting Data in Annual Reports
Shuping Chen (UT), Bin Miao (Singapore) and Terry J. Shevlin (California-Irvine)
Journal of Accounting Research (forthcoming)
We construct a new, parsimonious, measure of disclosure quality – disaggregation quality (DQ) – and offer validation tests. DQ captures the level of disaggregation of accounting data through a count of non-missing Compustat line items, and reflects the extent of details in firms’ annual reports. Conceptually DQ differs from existing disclosure measures in that it captures the ‘fineness’ of data and is based on a comprehensive set of accounting line items in annual reports. Unlike existing measures which are usually applicable for a subset of firms or are based on a subset of information items, DQ can be generated for the universe of Compustat industrial firms. We conduct three sets of validation tests by examining DQ’s association with variables predicted by prior literature to be associated with information quality. DQ is negatively (positively) associated with analyst forecast dispersion (accuracy), negatively associated with bid-ask spreads and cost of equity. These associations continue to hold after we control for firm fundamentals. Taken together, results from this battery of validation tests are consistent with our measure capturing disclosure quality.
Corporate Governance, Accounting Conservatism, and Manipulation
Judson Caskey (California) and Volker Laux (UT)
Management Science (forthcoming)
We develop a model to analyze how board governance affects firms' financial reporting choices, and managers' incentives to manipulate accounting reports. In our setting, ceteris paribus, conservative accounting is desirable because it allows the board of directors to better oversee the firm's investment decisions. This feature of conservatism, however, causes the manager to manipulate the accounting system to mislead the board and distort its decisions. Effective reporting oversight curtails managers' ability to manipulate, which increases the benefits of conservative accounting and simultaneously reduces its costs. Our model predicts that stronger reporting oversight leads to greater accounting conservatism, manipulation, and investment efficiency.
Firms with Inconsistently Signed Earning Surprises: Do Potential Investors Use a Counting Heuristic?
Lisa Koonce (UT) and Marlys Gascho Lipe (South Carolina)
Contemporary Accounting Research (forthcoming)
Although prior research reports that firms that consistently beat their earnings expectations are rewarded with a market valuation premium, most firms are inconsistent in the signs of their benchmark performance, sometimes missing and sometime beating. In this paper, we report the results of multiple experiments to test the idea that potential investors, evaluating firms that have inconsistent benchmark performance, use a counting heuristic to discriminate among them. Our results provide strong support for the hypothesis that these investors distinguish among firms by counting the number of beats and misses they experience over an observed time interval. The judgmental effect of this beat-frequency is incremental to the effect of the magnitude of the beats and misses of the benchmark. Our study has implications for researchers and firm managers.
The Role of D&O Insurance in Securities Fraud Class Action Settlements
Dain Donelson (UT), Justin Hopkins (Virginia), Cristopher Yust (A&M)
Journal of Law and Economics (forthcoming)
Due to previous data unavailability, it is unclear how important directors’ and officers’ (D&O) insurance is in securities fraud class action settlements. Using a unique dataset of U.S. D&O policies, we find that D&O coverage is a less significant determinant of settlement amounts than estimated damages and proxies for case merits. D&O limits are related to settlements in only the weakest cases (those without accounting allegations or institutional lead plaintiffs) where proxies for case merits play a minimal role. Our findings suggest that most securities fraud class action settlements are meritorious and accounting-related cases are a reasonable proxy for fraud.
Large Market Declines and Securities Litigation: Implications for Disclosing Adverse Earnings News
Dain Donelson (UT) and Justin Hopkins (Virginia)
Management Science (forthcoming)
This study examines the legal consequences of disclosing adverse earnings news when broad market indices face a large decline. The probability of litigation rises to 0.28% (from 0.16%), and settlements increase 50% over the median (by $1.8 million) when disclosure occurs during a large market decline. Further, cases filed when the class period falls on a large market decline are more likely to be dismissed and lead to larger settlements- consistent with judges, but not potential jurors, discounting the effects of market returns. Finally, we find no evidence that managers delay disclosures to avoid days with large market declines. This result could be attributable to high costs of this strategy, or managers not recognizing the legal consequences to disclosing adverse news on a day where the market declines significantly.
Non-Big 4 Local Market Leadership and its Effect on Competition
Marsha B. Keune (Dayton), Brian W. Mayhew(Wisconsin - Madison), and Jaime Schmidt (UT)
The Accounting Review (forthcoming)
This study examines local characteristics associated with non-Big 4 local market leadership and the impact of non-Big 4 local market leadership on competition. We identify non-Big 4 local market leaders by collecting accounting firm rankings from business publications for 46 of the largest metropolitan statistical areas from 2005 - 2010. These rankings are based on the number of local office employees and provide a more holistic measure of office size than measures based on public company audit fees. We find local supply and demand factors are significantly associated with non-Big 4 local market leadership and that non-Big 4 leadership is associated with lower overall audit fees in the local market. We also find that non-Big 4 leaders earn a fee premium over other non-Big 4 auditors. Our results imply that non-Big 4 leaders increase local market competition.
Heterogeneous Prior Beliefs, Differential Interpretation and the Consensus Effect of Quarterly Earnings Signals and Trading Volume
Rowland Atiase (UT), Alex Dontoh (NYU) and Michael Gift (Macau)
Journal of Accounting Auditing and Finance (forthcoming)
Models of financial economists including Karpoff (1986), Varian (1989), Holthausen and Verrecchia (1990), and Dontoh and Ronen (1993) 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 theoreticall
y, 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 paper 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.
Taxes and Financial Constraints: Evidence from Linguistic Cues
Kelvin K.F. Law (Tilburg - UT PhD) and Lillian F. Mills (UT)
Journal of Accounting Research, September 2015, 53(4), pp. 777-819
Corporations facing financial constraints, revealed by using a higher percentage of negative words in their financial reports, are more tax aggressive, freeing up additional funds in the short run.
Using a new measure of financial constraints based on firms’ qualitative disclosures, we find that financially constrained firms—firms that use more negative words in their annual reports—pursue more aggressive tax planning strategies as evidenced by: (1) higher current and future unrecognized tax benefits, (2) lower short- and long-run current and future effective tax rates, (3) increase in tax haven usage for their material operations, and (4) higher proposed audit adjustments from the Internal Revenue Service. We exploit the unexpected closures of local banks as exogenous liquidity shocks to show that firms’ external financial constraints affect their tax avoidance strategies. Overall, the linguistic cues in firms’ qualitative disclosures provide incremental information beyond traditional accounting variables or commonly used effective tax rates to reveal and predict tax aggressiveness, both contemporaneously and in the future.
Strategic Informed Trades, Diversification, and Expected Returns
Judson Caskey (UT), John S. Hughes (UCLA) and Jun Liu (UCSD)
The Accounting Review, September 2015, 90(5), pp. 1811-1837
We examine how strategic trade affects expected returns in a large economy. In our model, both a monopolist (strategic) informed trader and uninformed traders consider the impact of their demands on prices. In contrast to settings with price-taking traders, private information never eliminates a priced risk, and can lead to higher risk premiums. Also unlike settings with price-taking informed traders, risk premiums decrease in response to an increase in liquidity-motivated trades in diversified portfolios. These differing effects arise because a privately informed strategic trader conceals her trades by taking small positions relative to the magnitude of noise trades. Although prices partially reveal her information and reduce uncertainty, a concomitant decrease in her risk absorption dominates and leads to higher risk premiums. Similar to settings with price-taking traders, private information affects expected returns only via factor loadings and risk premiums on existing payoff risks – it introduces no new priced risks and factor loadings (betas) explain all cross-sectional differences in expected returns.
The Value of Identifying Operating Leases
Judson Caskey (UT) and N. Burgra Ozel (UCLA)
Bloomberg BNA Accounting Policy & Practice Report , 2015, 11(4), pp. 165-167
Critics claim that the off-balance-sheet treatment of operating leases not only fails to reflect economic reality, but also plays a major role in distorting companies' financing decisions. Partly in response to such criticisms, both the Financial Accounting Standards Board (FASB), which governs US GAAP, and the International Accounting Standards Board (IASB), which governs IFRS, have proposed revised lease accounting standards that will require the capitalization of all long-term leases, and will distinguish leases only on the basis of whether or not they pertain to real estate. A recent study of ours suggests that investors gain valuable information from the identification of operating leases, which the proposed rules will eliminate.
Earnings Metrics, Information Processing, and Price Efficiency in Laboratory Markets
W. Brooke Elliott (Illinois), Jessen Hobson (Illinois), and Brian White (UT)
Journal of Accounting Research, 2015, 53 (3), pp. 461-631
Including transitory elements in prominent earnings metrics causes investors to search unnecessarily for further information about these elements and to overestimate their effect on firm value relative to a rational benchmark; as a result, market prices are most efficient when transitory elements are excluded from earnings entirely.
The predictive qualities of earnings volatility and earnings uncertainty
Dain Donelson (UT) and Robert J. Resutek (Georgia)
Review of Accounting Studies, March 2015, 20 (1), pp. 470-500
This study examines the differential predictive power of past earnings volatility for analyst forecast errors and future returns. Past earnings volatility jointly captures two correlated, but distinct, earnings properties: time-series earnings variation and uncertainty in future earnings. To distinguish between these two earnings properties, we develop a forward-looking measure of earnings uncertainty that has a minimal mechanical link to variation in prior-period earnings realizations and does not rely on analyst forecasts. Our results suggest that future earnings uncertainty, and not time variation in earnings, is associated with overly optimistic future earnings expectations of equity analysts and investors. We provide the first empirical evidence on the relevance of future earnings uncertainty to analysts and investors over 1-year horizons. In addition, we provide empirical evidence showing that forecast dispersion is a poor measure of earnings uncertainty.
Audit Committee Financial Expertise and Earnings Management: The Role of Status
Patrick Badolato (UT), Dain Donelson (UT) and Matt Ege (Florida)
Journal of Accounting and Economics, 2014, 58(2-3), pp. 208-230
Regulatory pressure to increase both audit committee financial expertise and board independence has resulted in lower status for audit committees relative to management. This status differential is relevant because expertise and relative status are important determinants of each party’s ability to influence outcomes, particularly when parties face conflicting goals. We find that audit committees with both financial expertise and high relative status are associated with lower levels of earnings management, as measured by accounting irregularities and abnormal accruals. These results speak to benefits and limitations of financial expertise, which have been the focus of considerable debate.
The Informedness Effect and Volume of Trade
Rowland Atiase (UT) and Mike Gift (Macau)
Journal of Accounting Auditing & Finance, October 2015, 30(4), pp. 407-430
We find that the volume of trades immediately after a quarterly earnings announcement is higher when individual investors learn more differentially about firm value from the announcement, because investors are more likely to trade when there are differences in how confident they are in their knowledge.
Theoretical models of trade (Dontoh and Ronen, 1993; Holthausen and Verrecchia, 1990; Karpoff, 1986; Kim and Verrecchia, 1997; and Varian, 1989) show that information-based trading is a consequence of four fundamental determinants: heterogeneous prior beliefs, differential interpretations, the consensus effect, and the informedness effect. Although the effects of these determinants on trading volume are clear theoretically, there is no prior empirical evidence on the relation between the informedness effect and the volume of trade, nor is there any empirical evidence on the incremental effect of each of the four determinants on the volume of trade. This study provides empirical evidence to fill this void. Consistent with theoretical predictions in Holthausen and Verrecchia (1990), we find a significantly positive relation between the informedness effect and trading volume reactions to quarterly earnings announcements. We also find that the proxies for each of the four fundamental determinants of trading volume – prior belief heterogeneity, differential interpretation, the consensus effect, and the informedness effect of quarterly earnings signals – play a significant incremental role in explaining trading volume, thereby corroborating the theoretical results of financial economists. An important implication of our results is that empirical models of trade should consider controlling for each of these determinants.
Inside the “Black Box” of Sell-Side Financial Analysts
Lawrence D. Brown (Temple), Andrew C. Call (Arizona State), Michael Clement (UT) and Nathan Y. Sharp (Texas A&M)
Journal of Accounting Research, 2015, 53 (1), pp. 1-47
Our objective is to penetrate the “black box” of sell-side financial analysts by providing new insights into the inputs analysts use and the incentives they face. We survey 365 analysts and conduct 18 follow-up interviews covering a wide range of topics, including the inputs to analysts’ earnings forecasts and stock recommendations, the value of their industry knowledge, the determinants of their compensation, the career benefits of Institutional Investor All-Star status, and the factors they consider indicative of high-quality earnings. One important finding is that private communication with management is a more useful input to analysts’ earnings forecasts and stock recommendations than their own primary research, recent earnings performance, and recent 10-K and 10-Q reports. Another notable finding is that issuing earnings forecasts and stock recommendations that are well below the consensus often leads to an increase in analysts’ credibility with their investing clients. We conduct cross-sectional analyses that highlight the impact of analyst and brokerage characteristics on analysts’ inputs and incentives. Our findings are relevant to investors, managers, analysts, and academic researchers.
Why Do Ineffective Audit Committee Members Experience Turnover?
Steve Kachelmeier (UT), Stephanie Rasmussen (UT – Arlington), Jaime Schmidt (UT)
Contemporary Accounting Research (forthcoming)
Audit committee turnover often occurs when there is a need to restore perceived legitimacy of the board as predicted by legitimacy theory.
We use information extracted from a major proxy advisory service to test predictions from institutional theory regarding when and why audit committee (AC) members experience turnover due to evidence of ineffective governance. First, we broadly categorize AC ineffectiveness concerns as either (1) financial reporting failures or (2) characteristics of individual AC members. Institutional theory suggests that the visible nature of the first category is more likely to threaten perceptions of AC legitimacy and hence prompt turnover, which is what we find. We then enrich the analysis by interacting the AC-member ineffectiveness indicators with the extent of shareholder protest votes, finding that shareholder dissent elevates the turnover effects of both categories of ineffectiveness, as institutional theory would predict. Finally, we find that otherwise effective AC members face an increased likelihood of turnover if they serve on the AC when financial reporting failures are discovered, even if they were not on the AC when the events precipitating the failures occurred. Overall
The Disclaimer Effect of Disclosing Critical Audit Matters in the Auditor’s Report
Steve Kachelmeier (UT), Jaime Schmidt (UT), Kristen Valentine (UT)
If the PCAOB decides to require auditors to disclose “critical audit matters” (CAMs) in the audit report, such CAM disclosures could reduce investor confidence in the financial statement area that relates to the CAM and reduce auditor responsibility for a subsequently disclosed misstatement that relates to the CAM area.
Will disclosing critical audit matters (CAMs) in the auditor’s report, as the U.S. Public Company Accounting Oversight Board (PCAOB) has recently proposed, affect user confidence in the financial statements and the level of perceived auditor responsibility for a subsequently discovered material misstatement? The answers are important because increases in user confidence and perceived auditor responsibility for misstatements would imply greater legal exposure for auditors, while decreases would imply that CAMs act as a partial disclaimer of auditor responsibility. Using the CAM disclosure wording proposed by the PCAOB , we conduct an experiment that finds evidence consistent with a disclaimer effect. Specifically, participants perceive less confidence and less auditor responsibility for a misstatement in a financial statement area disclosed in the auditor’s report as a CAM than in a comparable financial statement area not disclosed as a CAM. Surprisingly, these findings arise whether or not the auditor’s report also discloses CAM-related audit procedures. Insofar as the PCAOB’s proposal warns auditors against using CAM wording to disclaim responsibility, the fact that we observe such an effect from the PCAOB’s illustrative wording for CAM disclosures warrants further policy consideration.
Does Concrete Language in Disclosures Increase Willingness to Invest?
W. Brooke Elliott (Illinois), Kristina M. Rennekamp (Cornell) and Brian White (UT)
Review of Accounting Studies, 2015, 20 (2), pp. 839-865
As part of its push for more plain English in disclosures, the SEC argues that firms should use more concrete language in order to make abstract concepts clearer to investors. In this study, we use experiments to show that, when concrete language is highlighted in a prospectus, investors are significantly more willing to invest in a firm than when abstract language is highlighted. Further, the effect of concrete language is particularly important when a firm feels more psychologically distant to an investor, either because the firm is located geographically further from the investor, or because the investor is less familiar with the firm’s location. Drawing on psychology theory, we predict and find that the effect of concrete language operates by increasing investors’ subjective feelings of comfort in their ability to evaluate a prospective investment. Our study contributes to the growing literature on how linguistic choices in corporate disclosures affect investors’ judgments and decisions by demonstrating a simple, yet potentially powerful reporting tool of emphasizing concrete language in disclosures for attracting investors who may otherwise be reluctant to invest.
Internal Control Weaknesses and Financial Reporting Fraud
Dain Donelson (UT), Matthew Ege (Florida), and John McInnis (UT)
Conference on Auditing and Capital Markets
This study examines whether and how weak internal controls increase the risk of financial reporting fraud by top managers. Since top managers can override controls, there is a longstanding debate on whether control strength significantly affects fraud risk, yet little evidence on this issue. In fact, prior work suggests that control weaknesses are linked to lower quality accruals associated with errors, not intentional manipulation. We find a strong association between material weaknesses and future fraud revelation. We theorize this link could be attributable to weak controls a) giving managers greater opportunity to commit fraud or b) signaling a management characteristic that does not emphasize reporting quality and integrity. We find support consistent with weak controls giving managers the opportunity to commit fraud through entity- not process-level controls. This supports the PCAOB’s assertion that entity-level controls reduce the risk of fraud and management override of controls.
Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk?
Keith Czerney (Illinois), Jaime J. Schmidt (UT) and Anne Thompson (Illinois)
The Accounting Review, 2014, 89 (6), pp. 2115-2149
Present-day audit reports communicate some information about financial reporting quality.
According to auditing standards, explanatory language added at the auditor’s discretion to unqualified audit reports should not indicate increased financial misstatement risk. However, an auditor is unlikely to add language that would strain the auditor-client relationship absent concerns about the client’s financial statements. Using a sample of 30,825 financial statements issued with unqualified audit opinions during 2000 – 2009, we find that financial statements with audit reports containing explanatory language are significantly more likely to be subsequently restated than financial statements without such language. We find that this positive association is driven by language that references the division of responsibility for performance of the audit, adoption of new accounting principles, and previous restatements. In addition, we find that (1) “emphasis of a matter” language that discusses mergers, related party transactions, and management’s use of estimates predicts restatements related to these matters and that (2) the financial statement accounts noted in the explanatory language typically correspond to the accounts subsequently restated. In sum, our results suggest that present-day audit reports communicate some information about financial reporting quality.
The Effect of Performance-Based Incentive Contracts on System 1 and System 2 Processing in Affective Decision Contexts: fMRI and Behavioral Evidence
Anne M. Farrell (Miami U), Joshua O. Goh (NIA) and Brian J. White (UT)
The Accounting Review, 2014, 89 (6), pp. 1979-2010
Managers may rely on emotional reactions to a setting to the detriment of economic considerations (“System 1 processing”), resulting in decisions that are costly for firms. While economic theory prescribes performance-based incentives to align goals and induce effort, psychology theory suggests that the salience of emotions is difficult to overcome without also inducing more deliberate consideration of both emotional and economic factors (“System 2 processing”). We link these perspectives by investigating whether performance-based incentives mitigate the costly influence of emotion by inducing more System 2 processing. Using functional magnetic resonance imaging (fMRI) and traditional experiments, we investigate managers’ brain activity and choices under fixed wage and performance-based contracts. Under both contracts, brain regions associated with System 1 processing are more active when emotion is present. Relative to fixed wage contracts, performance-based contracts induce System 2 processing in emotional contexts beyond that observed absent emotion, and decrease the proportion of economically costly choices.
Corporate Governance, Board Oversight, and CEO Turnover
Volker Laux (UT)
Foundations and Trends in Accounting, 2014, 8 (1), pp. 1-73
This monograph synthesizes recent research on the effects of CEO assessment and replacement on optimal contracting, board monitoring, project selection, financial reporting, and CEO selection.
One of the primary roles of corporate boards is to control the processes by which top executives are assessed and if necessary replaced. CEO turnover cannot be viewed in isolation because it affects the behavior of the involved players and hence interacts with other organizational goals. This monograph seeks to synthesize recent research that analyzes these interactions. I focus on a number of recurring themes, including the implications of CEO assessment and replacement on optimal contracting, board monitoring, project selection, financial reporting, and CEO selection.
The Effect of Mandatory Financial Statement Disclosures of Tax Uncertainty on Tax Reporting and Collections: The Case of FIN 48 and Multistate Tax Avoidance
Sanjay Gupta (MSU), Lillian F. Mills (UT), Erin Towery (Georgia – earned Ph.D at UT)
Journal of the American Taxation Association, 2014, 36 (2), pp. 203-229
The authors find that corporate state effective tax rates and aggregate state collections increased slightly following FASB’s issuance of Financial Interpretation No. 48. That guidance required firms to record liabilities for tax positions that failed to meet a more-likely-than-not threshold, arguably having a more important effect in multi-state taxation where audit detection is lower than in federal taxation.
This study investigates the effect of accounting measurement and disclosure requirements on multistate income tax avoidance. The proliferation of sophisticated state tax planning techniques combined with the complexity of varying state tax regimes make multistate taxation an area rampant with uncertainty. The accounting standards contained in FASB Interpretation No. 48 (FIN 48) require firms to record and disclose liabilities for uncertain income tax benefits based on a more-likely-than-not merit threshold of each tax position, assuming tax authorities have full information. Theoretical work and initial practitioner claims suggested that the accounting standards would increase reported tax expense and tax payments. Consistent with this, we find that both firm-level state income tax expense and aggregate state-level income tax collections increased surrounding adoption of FIN 48, providing evidence of the association between mandatory financial reporting disclosures and tax compliance behavior.
The predictive qualities of earnings volatility and earnings uncertainty
Dain C Donelson (UT) and Robert J. Resutek (Dartmouth)
Review of Accounting Studies, 2015, 20 (1), pp. 470-500
We provide the first empirical evidence on the relevance of future earnings uncertainty to analysts and investors over one-year horizons. In addition, we provide empirical evidence showing that forecast dispersion is a poor measure of earnings uncertainty.
This study examines the differential predictive power of past earnings volatility for analyst forecast errors and future returns. Past earnings volatility jointly captures two correlated, but distinct, earnings properties: time-series earnings variation and uncertainty in future earnings. To distinguish between these two earnings properties, we develop a forward-looking measure of earnings uncertainty that has a minimal mechanical link to variation in prior period earnings realizations and does not rely on analyst forecasts. Our collective results suggest that future earnings uncertainty, and not time variation in earnings, is associated with overly-optimistic future earnings expectations of equity analysts and investors. We provide the first empirical evidence on the relevance of future earnings uncertainty to analysts and investors over one-year horizons. In addition, we provide empirical evidence showing that forecast dispersion is a poor measure of earnings uncertainty.
Pay Convexity, Earnings Manipulation, and Project Continuation
Accounting Review, 2014, 89 (6), pp. 2233-2259
Reducing opportunistic reporting discretion does not necessarily reduce but can increase accounting manipulation.
This paper studies the optimal design of long-term executive pay plans when boards of directors use accounting information for investment decision-making and executives can take costly actions to manipulate this information. The model predicts that a shift to more convex executive pay plans (e.g., equity plans that are more option and less stock heavy) is associated with higher levels of manipulation, lower reporting quality, and less efficient investment. When designing the optimal contract, the board trades off these effects with the cost of inducing effort.
In addition, the paper analyzes how the optimal pay convexity and the equilibrium level of manipulation change when the financial reporting environment changes. The model shows that the magnitude of manipulation is an inverted U-shaped function of the CEO's opportunistic reporting discretion. Thus, a move to better governance (which increases the CEO's marginal cost of misreporting) first increases and then decreases the level of manipulation. With respect to CEO compensation, the model predicts greater emphasis on stock options relative to stock in firms with stronger governance.
Executive Pay, Innovation, and Risk-Taking
Journal of Economics and Management Strategy, 2015, 24 (2), pp. 275-305
The paper analyzes the optimal mix of stock options, restricted stock, and severance pay in executive pay plans.
This paper analyzes the optimal equity pay mix in a setting in which executives face career concerns and must be motivated to search for innovative investment ideas and to make appropriate decisions regarding whether to pursue the uncovered idea. I show that, depending on the value of the firm's potential growth opportunities and the CEO's concern about being fired, the CEO is either tempted to overinvest in risky ideas (excessive risk-taking) or underinvest in risky ideas (excessive conservatism). The optimal pay package consists of stock options, to encourage the discovery of innovative ideas, and either restricted stock, to combat excessive risk-taking, or severance pay, to combat excessive conservatism. The model provides new empirical predictions relating executive pay arrangements to the importance of innovation and career concerns and analyzes how the change in the economic environment caused by the current financial crisis might change the optimal mix of stock options, restricted stock, and severance pay.
Risk in Financial Reporting
CPA Magazine (January 2014)
Financial statement users’ judgments of risk are different from how risk is defined in economics.
Although there is a relative paucity of research on how financial statement users think about risk, what we do know is that their judgments of risk are different (i.e., broader) than how risk is typically defined in economics. Understanding this is important as it can provide important input to standard-setters and regulators as they grapple with the important topic of risk communication within financial reporting.
Does Intent Modify Risk-Based Auditing?
Steven J. Kachelmeier (UT), Tracie M. Majors (UT), and Michael G. Williamson (UT)
The Accounting Review, 2014, 89 (6), pp.2181-2201
Participants in an audit-like exhibited risk-based auditing reasoning to a lesser extent when risks arose from the intentional actions of human reporters than when the same risks arise from an unintentional source.
Risk-based auditing implies that auditors invest more (fewer) resources as reporting risks increase (decrease). We find from an interactive experiment that participants in an audit-like role reflect this reasoning to a lesser extent when risks arise from the intentional actions of human reporters than when the same risks arise from an unintentional source. We interpret this pattern as reflecting an emotive “valuation by feeling” when risks arise from human intent, meaning that the presence of such risk is more influential than the magnitude of risk, whereas unintentional risks reflect a “valuation by calculation” that weighs audit resources against the magnitude of risks faced. Because we construct intentional and unintentional risks that have equivalent magnitudes, probabilities, and consequences, these results could seem irrational in a strict economic sense. Outside the laboratory, however, if human intent makes auditors less sensitive to risk magnitudes, this propensity could make auditors less vulnerable to changes in the magnitudes of intent-based risks that arise from client responses to observed auditor strategies.
Inter-Industry Network Structure and the Cross- Predictability of Earnings and Stock Returns
Daniel Aobdia (Northwestern), Judson Caskey (UT), N. Bugra Ozel (UCLA)
Review of Accounting Studies, 2014, 19 (3), pp. 1191-1224
We examine how the patterns of inter-industry trade flows impact the transfer of information and economic shocks. We provide evidence that the intensity of transfers depends on industries’ positions within the economy. In particular, some industries occupy central positions in the flow of trade, serving as hubs. Consistent with a diversification effect, we find that these industries have more exposure to aggregate risks than do non-central industries. Additionally, earnings response coefficients of firms in central industries are lower than those of other firms, consistent with investors placing less emphasis on the firm-specific information on account of the relative importance of aggregate risk to central firms. Comparing central industries to non-central industries, we find that the stock returns and accounting performance of central industries better predict the performance of industries linked to them. This suggests that shocks to central industries propagate more strongly than shocks to other industries. Our results highlight how industries’ positions within the economy affect the transfer of information and economic shocks.
Litigation risk and agency costs: Evidence from Nevada corporate law
Dain C. Donelson (UT) and Christopher G. Yust (UT)
Journal of Law and Economics, 2014, 57 (3), pp.747-780
Officer and director litigation risk is an important governance mechanism that can impact firm value, managerial incentives, and impact on operating performance.
In 2001, Nevada significantly limited the personal legal liability of corporate officers and directors. We use this exogenous shock to implement a differences-in-differences design that examines the impact of officer and director litigation risk on agency costs. We find decreased firm value, especially for firms with lower levels of investor protection and with the highest expected agency costs. We also find that managerial incentives are reduced as measured by lower CEO pay-for-performance sensitivity. Finally, we find an adverse impact on operating performance and increased error-based restatements for Nevada firms subsequent to the change. Our findings emphasize that officer and director litigation risk is an important governance mechanism.
Public versus Private Firm Responses to the Tax Rate Reduction in China
Lillian Mills (UT), Kenny Z. Lin (Lingnan University), and Fang Zhang (Hong Kong Baptist University)
Journal of the American Taxation Association, Spring 2014, 36(1), pp. 137-163
Private firms in China saved about 8% of their total tax expense in 2007 by shifting income forward to 2008 when a rate cut from 33 to 25 percent took effect.
This study examines how public and private firms in China respond to the 2008 statutory tax rate reduction from 33 percent to 25 percent. Using a proprietary dataset of private firms, we find that private firms report significantly more income-decreasing current accruals than do public firms in 2007, the year prior to the tax rate reduction. These negative accruals were substantial and material, both compared with public firms and compared with 2008 accruals. By shifting their taxable income from a high- to a low-tax year, private firms save about 8.58 percent of their total tax expenses in 2007. Our results suggest that countries contemplating tax rate changes should expect material inter-temporal income shifting by private firms when they predict the short-term effects of changes in the tax rate on revenue.
Public Equity and Audit Pricing in the U.S.
Brad Badertscher (Notre Dame), Bjorn Jorgensen (Colorado), Sharon P. Katz (Columbia), William R. Kinney, Jr. (UT)
Journal of Accounting Research, May 2014, 52(2), pp. 303-339
Audit fees for public equity firms are typically higher than fees for otherwise similar private equity firms.
To what degree are audit fees for U.S. firms with publicly traded equity higher than fees for otherwise similar firms with private equity? The answer is potentially important for evaluating regulatory regime design efficiency and for understanding audit demand and production economics. For U.S. firms with publicly-traded debt, we hold constant the regulatory regime, including mandated issuer reporting and auditor responsibilities. We vary equity ownership and thus public securities market contextual factors, including any related public firm audit fees from increased audit effort to reduce audit litigation risk and/or pure litigation risk premium (litigation channel effects). In cross-section, we find that audit fees for public equity firms are 20% to 22% higher than fees for otherwise similar private equity firms. Time-series comparisons for firms that change ownership status yield larger percentage fee increases (decreases) for those going public (private). Results are consistent with litigation channel effects giving rise to substantial incremental audit fees for U.S. firms with public equity ownership.
The Effect of Using a Lattice Model to Estimate Reported Option Values
Brian Bratten (Kentucky), Ross Jennings (UT), and Casey Schwab (Georgia)
Contemporary Accounting Research,March 2015, 32(1), pp. 193-222
Recently, many companies have changed the model they use to value their employee stock option from the Black-Scholes model to the more flexible lattice model. Some argue that this model can provide more accurate option values, while others argue that its added flexibility can be used to understate reported option values. We investigate which is the case, whether companies use the added flexibility of the lattice model to report their option expense more accurately, or whether they use the added flexibility of the lattice model to further lower their stock option expense and increase reported income. We find that firms adopting a lattice model increase understatement of reported option values relative to firms that continue to use the Black-Scholes model. In contrast, we find no evidence that companies use a lattice model to improve the accuracy of reported option values. Thus, the evidence in this study indicates that firms adopt and implement lattice models primarily to lower reported option values.
Statement of Financial Accounting Standards 123R suggests that lattice valuation models may improve the estimates of reported employee stock option values relative to the more commonly used Black-Scholes model. However, lattice model critics have expressed concerns that managers may use lattice models’ flexibility to opportunistically understate option values. In this study, we investigate a sample of firms that recently adopted a lattice model to value employee stock options to provide evidence on this issue by identifying the determinants of lattice model adoption and examining the effect of lattice model use on reported option values. We report three main results. First, we find that firms are more likely to adopt a lattice model when it is more likely to produce lower values than the Black-Scholes model and when managers have incentives to lower stock option expense. Second, we find that firms adopting a lattice model increase understatement of reported option values more than firms that continue to use the Black-Scholes model and that the incremental understatement is due to use of the lattice model. Third, we conduct several tests to examine whether the valuation effect of lattice model use is consistent with efforts to correct for documented shortcomings in the Black-Scholes model and find no evidence that this is the case. Taken together, the evidence in this study suggests that firms adopt and implement lattice models primarily to lower reported option values.
Reflections on a decade of SOX 404(b) audit production and alternatives
William Kinney (University of Texas at Austin), Roger Martin (University of Virginia), Marcy Shepardson (Indiana University)
Accounting Horizons, December 2013, 27 (4), pp.799-813
In the decade since the July, 2002 passage of the quickly-legislated Sarbanes-Oxley Act, audit production in the U.S. has been substantially augmented by implementation of mandated internal control process audits. Audit production changes are important as the control audit mandate is unique and imposes substantial costs on U.S.-traded firms, yet little is known about the conduct of control process audits or the efficacy of substantially lower cost alternative mechanisms to provide auditor scrutiny and reporting on internal control quality. This paper reflects our collective experiences and observation of a consistent message across the decade from analyses of extensive public and limited non-public archival data, analytical studies, and numerous personal experiences of audit practitioners. Our primary observation is that, absent knowledge of any financial misstatements, auditors find it difficult to identify material weaknesses in internal control over financial reporting. Conversely, with knowledge of misstatements, auditors can and do identify, at low incremental cost, most entities that have ineffective internal controls as identified by control audits. Financial misstatement detection is, of course, the primary tangible output of a financial statement audit. Thus, it appears possible to exploit this observation to obtain for investors information about companies with weak controls without incurring the cost of a full internal control process audit. We believe that U.S. markets could benefit from more transparency about the current U.S. audit production process and from informed debate about the best mechanism design for balancing the needs of all parties interested in internal control quality disclosure.
Communicated Values as Informal Controls: Gaining Accuracy While Undermining Productivity?
Steven J. Kachelmeier (UT), Todd A. Thornock (Iowa State University), and Michael G. Williamson (UT)
Contemporary Accounting Research Conference
We use experimentation to show that a statement emphasizing the importance of accuracy can actually lower the effectiveness of an incentive scheme to motivate accurate production. The likely reason is that too much emphasis on accuracy can suppress a more open production strategy that tolerates and corrects mistakes as a means to greater long-term efficiency.
Using a laboratory letter-search task, we predict and find that the effectiveness of a piece-rate incentive scheme relative to fixed pay hinges on the presence or absence of a statement to participants that the experimenter values correct responses. In the absence of the value statement, participants with piece-rate rewards for correct responses improve production by generating more correct and incorrect responses than do their counterparts with fixed pay, correcting errors as they go along to maximize compensation. Conversely, when the statement about valuing correct responses is present, piece-rate incentivized participants suppress the adaptive strategy that willingly accepts (and corrects) errors in order to maximize overall production. Notably, the greater care for accuracy in the condition with the value statement comes at the expense of eliminating the productivity gains that piece-rate incentivized participants realize without the value statement. Thus, we examine a setting in which communicating what the organization desires negates the effectiveness of an incentive compensation scheme to achieve that objective.
The Effects of Norms on Investor Reactions to Derivative Use
Lisa Koonce (UT), Jeffrey S. Miller (Notre Dame), and Jennifer Winchel (South Carolina)
Contemporary Accounting Research Conference
Our study suggests that investors’ reactions to firms’ derivative use (or non-use) are more complex than previously contemplated. The prior research in this area concludes that derivative use has a positive effect on firm valuation, presumably because of the greater decision making care exhibited by those firms who choose to hedge risks via derivatives. Our study extends these findings by showing that this positive relationship is influenced by industry norms, and that the relationship can actually reverse when a firm’s choices regarding derivatives are not the same as the industry norm. We also show that industry norms are viewed as stronger indicators of appropriate behavior than are firm norms.
Prior research indicates that a firm’s use of derivatives to manage business risks is viewed favorably by investors. However, these studies do not consider a potentially key factor in this setting — namely, the typical behavior (or norms) regarding derivatives by other firms in the industry or the firm itself. In this paper, we report the results of multiple experiments that test whether norms are influential in affecting investors’ evaluations of firms’ derivatives choices. Our results show that the generally favorable reactions to derivative use may actually reverse and become unfavorable, depending on the industry and firm norms regarding derivatives. Somewhat surprisingly, though, we find that industry and firm norms are not viewed similarly by investors.
Regulation FD: A Review and Synthesis of the Academic Literature
Adam S. Koch (Virginia), Craig E. Lefanowicz (Virginia), and John R. Robinson (UT)
Accounting Horizons, 2013, 27(3), pp. 619-646
FD’s prohibition against the selective disclosure of material information eliminates the information advantage enjoyed by certain investors and analysts and thereby provides a more level playing field for all investors. However, an unintended consequence of Fair Disclosure is a reduction in the total amount of information available in the market (i.e., a “chilling effect”) for small or high-technology firms. Ongoing research suggests that private access to management continues to provide select analysts or investors with non-material information used to complete the “mosaic” of information.
We summarize the empirical evidence regarding Regulation Fair Disclosure (FD) to gauge whether the regulation achieves its stated objectives and to provide insights and direction for future research. Overall, we find that FD’s prohibition against the selective disclosure of material information eliminates the information advantage enjoyed by certain investors and analysts and thereby provides a more level playing field for all investors. In addition, a number of firms respond to FD by expanding public disclosures and the information environment of the average firm does not appear to be adversely affected. However, we find that an unintended consequence of FD is a reduction in the total amount of information available in the market (i.e., a “chilling effect”) for small or high-technology firms. Finally, ongoing research suggests that private access to management continues to provide select analysts or investors with non-material information used to complete the “mosaic” of information.
Conservatism and Equity Ownership of the Founding Family
Shuping Chen (UT), Xia Chen (Singapore), Qiang Cheng (Singapore)
European Accounting Review, 2014, 23 (3), pp. 403-430
The substantial stake of family owners means that these owners stand to bear a large share of the costs of such price protection and the costs of litigation. Family owners therefore have strong incentives to demand conservative financial reporting in order to reduce legal liability and mitigate agency costs. Family owners are also actively involved in the firm as directors so that they have abilities to influence financial reporting policies. Thus we expect to find that conservatism increases with family equity ownership.
We investigate the impact of founding family ownership on accounting conservatism. Family ownership is characterized by large, under-diversified equity stake and long investment horizon. These features give family owners both the incentives and the ability to implement conservative financial reporting to reduce legal liability and mitigate agency conflicts with other stakeholders. Since CEOs can have different incentives toward conservatism, we focus on ownership of non-CEO founding family members in our investigation. We find that conservatism increases with non-CEO family ownership, supporting our prediction. This relationship becomes insignificant in family firms with founders serving as CEOs, either due to founder CEOs’ incentives to implement more conservative financial reporting or their power to thwart non-CEO family owners’ demand for conservatism. Overall, our paper adds to the literature on the impact of founding family ownership on firms’ financial reporting policy. Our findings are consistent with the recent evidence in the family firm literature that founding families exhibit substantial incentives to reduce agency and litigation costs and to maximize firm value.
Short-Term Earnings Guidance and Earnings Management
Andrew C. Call (Arizona), Shuping Chen (UT), Bin Miao (NTU), Yen H. Tong (NTU)
Review of Accounting Studies, 2014, 19 (2), pp. 955-987
Contrary to conventional wisdom that short-term guidance fosters earnings management, we find that firms providing short-term earnings guidance exhibit lower absolute abnormal accruals, indicating these firms engage in less earnings management. Regular earnings guiders also exhibit less earnings management than do less regular guiders.
We study the relation between short-term earnings guidance and earnings management. We find that firms issuing short-term earnings forecasts exhibit significantly lower absolute abnormal accruals, our proxy for earnings management, than do firms that do not issue earnings forecasts. Regular guiders also exhibit less earnings management than do less regular guiders. These findings are contrary to conventional wisdom but consistent with the implications of Dutta and Gigler (2002) and the expectations alignment role of earnings guidance (Ajinkya and Gift 1984). Our results continue to hold after we control for self-selection and potential reverse causality concerns, and in a setting where managers are documented to have strong incentives to manage earnings. Additional analysis reveals that guiding firms exhibit less income-increasing accrual management whether firms guide expectations upwards or downwards, and no evidence that guiding firms inflate earnings through real activities management. We also provide evidence to demonstrate that meeting-or-beating benchmarks is not an appropriate proxy for earnings management in our research setting.
The Evolution of Capital Structure and Operating Performance After Leveraged BuyOuts: Evidence from U.S. Corporate Tax Returns
Jonathan B Cohn (UT), Lillian F. Mills (UT), Erin M. Towery (UT)
Journal of Financial Economics, 2014, 111(2), pp.469-494
Prior research on Leveraged Buyouts(LBO) concluded from available public data that operating performance improved post LBO. In in a broader dataset of public and private firms using confidential tax return data, we find little overall evidence of such improvements.
This study uses corporate tax return data to examine the evolution of firms' financial structure and performance after leveraged buyouts for a comprehensive sample of 317 LBOs taking place between 1995 and 2007. We find little evidence of operating improvements subsequent to an LBO, although consistent with prior studies, we do observe operating improvements in the set of LBO firms that have public financial statements. We also find that firms do not reduce leverage after LBOs, even if they generate excess cash flow. Our results suggest that effecting a sustained change in capital structure is a conscious objective of the LBO structure.
Predicting Credit Losses: Loan Fair Values versus Historical Costs
Brett Wooten Cantrell (UT), John M. McInnis (UT), and Christopher G. Yust (UT)
The Accounting Review, 2013, 89 (1), pp. 147-176
If you are looking at a bank’s financial statements to try to predict the extent to which their loans will go bad, you should look at historical loan costs minus the loan loss reserve rather than reported loan fair values. This is important because many people (including standard setters) claim loan fair values are better at predicting credit losses.
Standard setters and many investor groups have argued that fair values for loans provide more useful information about credit losses than historical cost information. Bankers and others generally disagree. We examine the ability of loan fair values to predict credit losses relative to the ability of net historical costs currently recognized under U.S. GAAP. Our analysis is important because credit losses in the banking sector can have severe and widespread economic effects, as the recent credit crisis demonstrates. Overall, we find that net historical loan costs are generally a better predictor of credit losses than loan fair values. Specifically, we find that historical cost information is more useful at predicting future net chargeoffs, non-performing loans, and bank failures over both short and long time horizons. Further tests indicate that the relative predictive ability of loan fair values improves in higher scrutiny environments, suggesting that a lack of scrutiny over loan fair values may contribute to our findings.
Productivity-Target Difficulty, Performance-Based Pay and Outside-the-Box Thinking
Alan Webb (Waterloo), Michael G. Williamson (UT), and Yue May Zhang (Northeastern)
The Accounting Review, 2013, 88 (4), pp.1433-1457
Increasing productivity target difficulty and tying compensation to meeting/beating these targets encourage employees to work harder, but also encourages employees to use conventional task approaches rather than thinking outside-the-box to identify more efficient approaches.
In an environment where individual productivity can be increased through efforts directed at a conventional task approach and more efficient task approaches that can be identified by thinking outside-the-box, we examine the effects of productivity-target difficulty and pay contingent on meeting and beating this target (i.e., target-based pay). We argue that while challenging targets and target-based pay can hinder the discovery of production efficiencies, they can motivate high productive effort (i.e., motivate individuals to work harder and more productively using either the conventional task approach or more efficient task approaches when discovered). Results of a laboratory experiment support our predictions. Individuals both assigned an easy productivity target and paid a fixed wage identify a greater number of production efficiencies than those with either challenging targets or target-based pay. However, individuals with challenging targets and/or target-based pay have higher productivity per production efficiency discovered suggesting these control tools better motivate productive effort. Collectively, our results suggest that the ultimate effectiveness of these control tools will likely hinge on the importance of promoting the discovery of production efficiencies relative to motivating productive effort. In doing so, our results provide a better understanding of conflicting prescriptions from the practitioner literature and business press.
When are Enhanced Relationship Tax Compliance Programs Mutually Beneficial?
Lisa De Simone (UT), Richard Sansing (Dartmouth), and Jeri Seidman (UT)
The Accounting Review, November 2013, 88 (6), pp.1971
An enhanced relationship program is a program under which taxpayers commit to voluntarily disclosing uncertain tax positions to tax authorities in exchange for timely resolution of these uncertainties. Our model suggests that despite the inherent adversarial nature of the taxpayer-tax authority relationship, these programs are mutually beneficial in many settings because in the program, taxpayers claim fewer weak positions and tax authorities are able to avoid auditing strong positions (on which they recover less than their audit cost, on average.)
This study investigates the circumstances under which “enhanced relationship” tax compliance programs are mutually beneficial to taxpayers and tax authorities, as well as how these benefits are shared. We develop a model of taxpayer and tax authority behavior inside and outside of an enhanced relationship program. Our model suggests that, despite the adversarial nature of the relationship, an enhanced relationship program is mutually beneficial in many settings. The benefits are due to lower combined government audit and taxpayer compliance costs. These costs are lower because taxpayers are less likely to claim positions with weak support and the government is less likely to challenge positions with strong support inside the program. Further, we show that an increase in the ability of the tax authority to identify uncertain tax positions makes an enhanced relationship tax compliance program more attractive to both the taxpayer and the tax authority.
The Role of Financial Reporting Quality in Mitigating the Constraining Effect of Dividend Policy on Investment Decisions
Santhosh Ramalingegowda (Georgia), Chuan-San Wang (Taiwan), and Yong Yu (UT)
The Accounting Review, 2013, 88(3), pp. 1007-1039
High quality financial reporting mitigates the risk that firms have to forgo valuable investment projects in order to pay dividends.
Miller and Modigliani’s (1961) dividend irrelevance theorem predicts that in perfect capital markets dividend policy should not affect investment decisions. Yet in imperfect markets, external funding constraints that stem from information asymmetry can force firms to forgo valuable investment projects in order to pay dividends. We find that high quality financial reporting significantly mitigates the negative effect of dividends on investments, especially on R&D investments. Further, this mitigating role of financial reporting quality is particularly important among firms with a larger portion of firm value attributable to growth options. In addition, we show that the mitigating role of high quality financial reporting is more pronounced among firms that have decreased dividends than among firms that have increased dividends. These results highlight the important role of financial reporting quality in mitigating the conflict between firms' investment and dividend decisions and thereby reducing the likelihood that firms forgo valuable investment projects in order to pay dividends.
The Pricing Effects of Securities Class Action Lawsuits and Litigation Insurance
Journal of Law, Economics, and Organization, 2014, 30 (4)
Securities litigation only impacts firm value via transaction costs such as attorney fees, and litigation insurance reduces these transaction costs.
The price reactions to corrective disclosures often serve as a benchmark for settlements in securities class action lawsuits. When the firm bears litigation costs, this benchmark creates a feedback effect that exacerbates the price reaction to news that contradicts managers' earlier reports. Litigation insurance provides value in this setting by reducing the need for investors to price the effects of anticipated litigation. Insurance also affects how changes in the litigation environment impact the firm, with some changes having opposite effects on the frequency of lawsuits against uninsured and insured firms. The pricing behavior of rational investors eliminates the valuation impact of the portion of settlements paid to investors, similar to dividends. The valuation impact of litigation arises from transaction costs, such as attorney fees, that the firm can mitigate by constraining misreporting and by purchasing insurance.
The Effect of Political Sensitivity and Bargaining Power on Taxes: Evidence from Federal Contractors
Lillian F. Mills (UT), Sarah E. Nutter (George Mason), Casey M. Schwab (Georgia)
The Accounting Review, 2013, 88(3), pp. 977-1005
Contractors whose contracts are large absolutely or in proportion to their revenues pay more taxes, consistent with political cost theory. However, this relationship is unwound by greater bargaining power, such as that enjoyed by sole-source or defense contractors.
We investigate whether politically sensitive contractors pay higher taxes and whether their bargaining power reduces these tax costs. Using federal contractor data, we develop a new composite measure of political sensitivity that captures both the political visibility arising from federal contracts and the importance of federal contracts to the firm. We proxy for bargaining power using the firm-level proportion of contract revenues not subject to competition, the firm-level proportion of contract revenues arising from defense contracts, and industry-level concentration ratios. We find that politically sensitive firms pay higher federal taxes, all else equal. However, firms with greater bargaining power incur fewer tax-related political costs. Our study provides new evidence on the political cost hypothesis in a tax setting and the first evidence of the interactive effects of a firm’s political sensitivity and bargaining power on tax-related political costs.
Dividend Policy at Firms Accused of Accounting Fraud
Judson Caskey (UT) and Michelle Hanlon (MIT)
Contemporary Accounting Research,2013, 30(2), pp. 818-850
By comparing dividend policies of firms accused of accounting fraud to those not accused of accounting fraud, it is determined that dividend paying status is negatively associated with the probability of committing accounting fraud.
Recent studies and some policy experts have posited that dividends indicate higher quality earnings. In this study, we test this conjecture by comparing the dividend policies of firms accused of accounting fraud to those of firms not accused of accounting fraud. Specifically, we examine whether alleged fraud firms are as likely to be dividend payers as non-fraud firms and whether managers of dividend-paying fraud firms increase dividends at the same rate as managers of non-fraud firms. Our data reveal that dividend paying status is negatively associated with the probability of committing accounting fraud. In addition, we also find that, during the alleged fraud period, the earnings-dividends relation is weaker for the alleged fraud firms relative to firms not accused of fraud. Finally, using propensity score match tests, the data provide evidence that managers of alleged fraud-firms increase dividends less often than managers of firms not accused of fraud, consistent with the alleged fraud firms not being able to match the dividend policies of firms not accused of fraud. Overall, our results suggest that dividends, especially dividend increases, are associated with higher earnings quality.
Group Audits, Group-Level Controls, and Component Materiality: How Much Auditing Is Enough
Trevor Stewart (Rutgers) and William Kinney (UT)
The Accounting Review, 2013, 88(2), pp.707-737
Through the application of a Bayesian group audit model, it is determined that group-level controls and structured subgroups of components are central to efficient group audits.
Auditing standards now mandate that group auditors determine and implement appropriate component materiality amounts, which ultimately affect group audit scope, reliability, and value. However, standards are silent about how these amounts should be determined and methods being used in practice vary widely, lack theoretical support, and may either fail to meet the audit objective or do so at excessive cost. We develop a Bayesian group audit model that generalizes and extends the single-component audit risk model to aggregate assurance across multiple components. The model formally incorporates group auditor knowledge of group-level structure, controls, and context as well as component-level constraints imposed by statutory audit or other requirements. Application of the model yields component materiality amounts that achieve the group auditor's overall assurance objective by finding the optimal solution on an efficient materiality frontier. Numerical results suggest group-level controls and structured subgroups of components are central to efficient group audits.
Are analysts’ forecasts naïve extensions of their own forecasts?
Andrew Call (Georgia), Shuping Chen (UT), and Yen H. Tong (Singapore)
Contemporary Accounting Research, 2013, 30(2), pp. 438-465
Analysts’ cash flow forecasts are not simply naïve extensions of their own earnings forecasts, they also reflect meaningful and useful accrual adjustments.
We examine the sophistication of analysts’ cash flow forecasts to better understand what accrual adjustments, if any, analysts make when forecasting cash flows. As a preliminary step, we first demonstrate that prior empirical tests used to evaluate the sophistication of analysts’ cash flow forecasts are not diagnostic. We then present three sets of evidence to triangulate our conclusion that analysts’ cash flow forecasts incorporate meaningful accrual adjustments. First, we review a stratified random sample of 90 analyst reports and find that the majority of these analysts include explicit adjustments for working capital and other accruals in their cash flow forecasts. Second, using a large sample of analysts’ cash flow forecasts from 1993-2008, we find that these forecasts outperform time-series cash flow forecasts in correctly predicting the sign and magnitude of accruals. Finally, we find a significant market reaction to analysts’ cash flow forecast revisions, suggesting that investors find these revisions informative. Collectively, our findings demonstrate that analysts’ cash flow forecasts are not simply naïve extensions of their own earnings forecasts, but that they reflect meaningful and useful accrual adjustments. These findings are relevant to researchers who examine analysts’ cash flow forecasts in a variety of settings, and to investors and practitioners who employ these forecasts for valuation purposes.
Home country investor protection, ownership structure and cross-listed firms' compliance with SOX-mandated internal control deficiency disclosures
Guojin Gong (Penn State), Bin Ke (Nanyang), and Yong Yu (UT)
Contemporary Accounting Research, 2013, 30 (40), pp.1490-1523
Home-country investor protection and ownership structure influences cross-listed firms' (non)compliance with U.S. disclosure rules.
We examine whether home country investor protection and ownership structure affect cross-listed firms’ compliance with SOX-mandated internal control deficiency (ICD) disclosures. We develop a proxy for the likelihood of ICD misreporting during the Section 302 reporting regime based on Ashbaugh-Skaife et al. (2007). For cross-listed firms domiciled in weak investor protection countries, we have three main findings. First, firms whose managers control their firms and have voting rights in excess of cash flow rights have a higher likelihood of ICD misreporting than other firms during the Section 302 reporting regime. Second, there is a positive association between the likelihood of ICD misreporting and voluntary deregistration from the SEC prior to the Section 404 effective date. Third, for firms that chose not to deregister, there is a positive association between the likelihood of ICD misreporting and the reporting of previously undisclosed ICDs during the Section 404 reporting regime. We do not find similar evidence for cross-listed firms domiciled in strong investor protection countries. Our evidence is consistent with the hypothesis that for cross-listed firms domiciled in weak investor protection countries, managers who have the ability and incentive to expropriate outside minority shareholders are reluctant to disclose ICDs in order to protect their private control benefits.
Testing Analytical Models Using Archival or Experimental Methods
Shane S. Dikolli (Duke), J. Harry Evans (Pittsburgh), Jeffrey Hales (Georgia Tech), Michal Matejka (Arizona), Don Moser (Pittsburgh), and Michael G. Williamson (UT)
Accounting Horizons, 2013, 27 (1), pp. 129-139
This paper highlights the advantages and disadvantages of combining an analytical model with archival or experimental data in a single study. It concludes with a brief discussion of how such studies are likely to fare in the journal review process.
Analytical models can quite naturally complement empirical data, whether archival or experimental. This article begins by discussing the advantages and disadvantages of combining an analytical model with archival or experimental data in a single study. We next describe how models are typically used in empirical research and discuss when including an analytical model is more versus less useful. Finally, we offer examples of more and less successful combinations of analytical models and empirical data, along with a brief discussion of how such studies are likely to fare in the journal review process.
Reward System Design and Group Creativity: An Experimental Investigation
Clara Xiaoling Chen (Illinois), Michael G. Williamson (UT), and Flora H. Zhou (Illinois)
The Accounting Review, 2012, 87(6), pp. 1885-1911
Our results advance the burgeoning management accounting literature on creativity-contingent incentives by suggesting that reward systems are more likely to promote creativity through collaborative, rather than independent individual, efforts. We also provide important insights into when and why tournament pay can boost creativity in organizations.
In an environment where three-person groups develop a creative solution to an important problem, we examine whether the efficacy of either individual or group-based creativity-contingent incentives depends on whether they take the piece-rate or tournament form. We predict and find that group (intergroup) tournament pay increases group cohesion and collaborative efforts, which ultimately lead to a more creative group solution relative to group piece-rate pay. While individual (intragroup) tournament pay increases individual efforts, we find that it does not enhance the creativity of group solutions relative to individual piece-rate pay. Our results advance the burgeoning management accounting literature on creativity-contingent incentives by demonstrating that reward systems are more likely to promote group creativity through collaborative efforts rather than independent individual efforts. We also provide important insights into when and why tournament pay can boost group creativity in organizations. In doing so, we contribute to a better understanding of observations from practice suggesting that organizations valuing creativity often induce intergroup competition.
The Timeliness of Earnings News and Litigation Risk
Dain Donelson (UT), John McInnis (UT), Richard Mergenthaler (Iowa), and Yong Yu (UT)
The Accounting Review, 2012, 87 (6), pp. 1967-1991
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.
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.
Managerial Reporting, Overoptimism, and Litigation Risk
Volker Laux and Phillip Stocken
Journal of Accounting and Economics, 2012, 53(3). pp. 577-591
We show that a heightened threat of litigation can increase incentives for managerial misreporting.
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.
Perceived Auditor Independence and Audit Litigation: The Role of Nonaudit Services Fees
The Accounting Review, 2012, 87 (3), pp. 1033-1065
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.
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.
Stock option vesting conditions, CEO turnover, and myopic investment
Journal of Financial Economics, 2012, 106 (3), pp. 513-526
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.
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.
The Extent of Implicit Taxes at the Corporate Level and the Effect of TRA86
Ross Jennings, Connie D. Weaver and William J. Mayew
Contemporary Accounting Research, 2012, 29 (4), pp. 1021-1059
When Congress passes a tax break like a credit for buying equipment, competitive forces may shift that explicitly benefit 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.
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.
A Post-SOX Examination of Factors Associated with the Size of Internal Audit Functions
Urton L. Anderson, Margaret H. Christ, Karla M. Johnstone, and Larry Rittenberg
Accounting Horizons, 2012, 26(2), pp. 167-191
This paper develops and test a model that can be used to assist internal audit directors and audit committees in answering the question of how much of an organization’s resources should be dedicated to the internal audit function.
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
Boochun Jung, Philip B. Shane, and Sunny Yanhua Yang
Journal of Accounting and Economics,2012, 53 (1-2), pp.55-76
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.
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, 2013, 30(1), pp.242-268
A disproportionate number of firms appear to just avoid losses, earnings declines, and miss 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.
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.