Targets' Tax Shelter Participation and Takeover Premiums

This paper examines the effect of targets' participation in tax shelters on takeover premiums in mergers and acquisitions. Using a novel data set in which targets disclose that they have not participated in tax shelters, we find that targets that make this statement in their merger filings are associated with 4.6 percent higher takeover premiums, on average. These findings suggest that acquirers are concerned about the potential future liabilities when targets have engaged in tax sheltering. Consistent with this interpretation, the results also indicate that the positive association between targets' nonsheltering disclosure and acquisition premiums is stronger for less tax‐aggressive acquirers. This paper demonstrates the importance of targets' aggressive tax positions in the determination of premiums offered to targets' shareholders.     

Contracting and Reporting Conservatism around a Change in Fiduciary Duties*

We exploit an influential 1991 Delaware court ruling to examine simultaneously two types of conservatism that play important roles in resolving creditor–owner agency conflicts: contracting conservatism and reporting conservatism. The ruling expanded managerial fiduciary duties in favor of creditors for Delaware-incorporated firms in the vicinity of insolvency. In those firms, following the ruling, debt contracts are less likely to include conservative adjustments to accounting numbers used for covenant compliance (i.e., contracting conservatism decreases), while public financial reporting becomes more conservative (i.e., reporting conservatism increases). The decrease in contracting conservatism is concentrated in firms that exhibit a greater increase in reporting conservatism, suggesting that reporting conservatism is more cost-effective in resolving agency conflicts. In addition, the substitution effect is more pronounced in firms facing greater business uncertainty and firms with greater board independence.     

Auditor Responses to Shareholder Activism

In this paper, we investigate how auditors respond to shareholder activism against their clients. Our study is important because activism may be viewed by auditors as a source of increased engagement risk, thereby impacting audit outcomes. The potential relationship between shareholder activism and audit outcomes leads us to predict that activism targets will pay higher audit fees and also will be more likely to receive adverse internal control opinions (ICOs) and first‐time going concern opinions (GCOs). Our results, which support all three predictions, suggest that the public scrutiny associated with activism campaigns heightens auditors' concerns about reputational damage and litigation risk. Consistent with this notion, we find that activism targets are more likely to experience accounting‐related lawsuits. We also find that the increased likelihood of adverse ICOs documented in our baseline tests reflects higher‐quality reporting rather than increased auditor conservatism. Overall, our findings suggest that activism campaigns spur auditor diligence while also increasing the possibility of negative outcomes that may not be fully anticipated by activist investors.     

Financial Statement Comparability and the Efficiency of Acquisition Decisions

This study examines whether acquirers make better acquisition decisions when target firms’ financial statements exhibit greater comparability with industry peer firms. We predict and find that acquirers make more profitable acquisition decisions when target firms’ financial statements are more comparable—as evidenced by higher merger announcement returns, higher acquisition synergies, and better future operating performance. We also find that post‐acquisition goodwill impairments and post‐acquisition divestitures are less likely when target firms’ financial statements are more comparable. Finally, we find that acquirers benefit most from comparability when acquirers’ ex ante information asymmetry is higher, acquirers operate in volatile operating environments, and management knows relatively less about the target. In total, our evidence suggests targets’ financial statement comparability helps acquirers make better acquisition‐investment decisions and fosters more efficient capital allocation.     

Individual Investors' Attention to Accounting Information: Evidence from Online Financial Communities*

Online financial communities provide a unique opportunity to directly examine individual investors' attention to accounting information on a large scale and in great detail. I analyze accounting-related content in large samples of Yahoo! message board posts and StockTwits and find investors pay attention to a range of accounting information, fixating particularly on earnings, cash, and revenues. Consistent with the expectation that investors react to relevant information events, I find accounting-related discussion elevated around the filings of earnings releases and 8-K reports, but the reaction to periodic reports is confined to small firms. I also find investors expand their acquisition of accounting information and processing efforts in poor information environments. Greater attention to accounting information at earnings releases does not appear to be meaningfully associated with better information processing.     

The Commitment to Income-Decreasing Accounting Choices as a Credible Signal to Reducing Information Asymmetry: The Case of Asset Revaluations*

Bagnoli and Watts (2005) proposed that a manager could reduce information asymmetry by choosing an income-decreasing accounting choice that signals the firm's relatively good future prospects. A limitation in testing this theory is that most income-decreasing accounting choices over time reverse such that aggregated earnings would be the same, regardless of the choice. One income-decreasing accounting choice that never reverses is the choice of upward asset revaluation, where the resulting gains are recognized through other comprehensive income and reduce future earnings by increasing future depreciation expense. In the United Kingdom, prior to FRS15, firms had the option to upwardly revalue on a one-time basis. FRS15, and subsequently International Financial Reporting Standards, however, require those firms that upwardly revalue precommit to revalue on a consistent basis. This precommitment sacrifices future reporting discretion, which, according to the aforementioned study, serves as a costly signal of a firm's relatively good future prospects that reduces information asymmetry. The choice not to upwardly revalue, therefore, serves as a signal of a firm's relatively poor future prospects and also reduces information asymmetry, but this choice does not require precommitment such that the reduction in information asymmetry would be less than the choice to precommit to upward revaluations. Using a propensity-score matched-pair design on a sample of United Kingdom firms to test our predictions during the period requiring precommitment, we find lower forecast dispersion, lower return volatility, and a lower cost of capital for firms that precommit to upward asset revaluations, relative to those firms that choose not to upwardly revalue their operating assets. Keywords: upward asset revaluations, income-decreasing accounting choice, information asymmetry, precommitment     

Auditing Goodwill in the Post‐Amortization Era: Challenges for Auditors

The elimination of goodwill amortization in 2001 brought about significant change in how companies are required to account for goodwill. This change in accounting also brought with it new challenges for auditors, namely evaluating the reasonableness of management's assumptions related to goodwill valuation. In addition to introducing technical challenges, this task is particularly difficult given the misalignment in incentives it creates between managers who likely prefer to avoid recording an impairment and auditors who seek to minimize the bias in management's impairment testing. This study focuses on the consequences of the misaligned incentives that auditors face under the current goodwill assessment process. We find that the decision to record a goodwill impairment is associated with an increase in the probability of auditor dismissal. Consistent with the presence of significant friction with clients, our results also indicate that the likelihood of auditor dismissals is negatively related to the favorability of the impairment decision. Furthermore, we find that companies impairing goodwill prior to dismissing auditors subsequently employ auditors that are, on average, more favorable to clients in their impairment decisions.     

Does Accounting Conservatism Discipline Qualitative Disclosure? Evidence From Tone Management in the MD&A*

We investigate whether accounting conservatism, which has been found to be effective in constraining management opportunism in other settings, constrains upward tone management (UTM) in the Management's Discussion and Analysis (MD&A) portion of the 10-K filing. We hypothesize that conservatism makes it harder for managers to opportunistically downplay bad news and magnify good news when discussing current performance. Consistent with this hypothesis, we find that UTM is negatively associated with several accounting conservatism proxies. Additionally, we hypothesize and find that this association is stronger for firms where managers have higher incentives to manipulate tone. In supplemental analyses, we find evidence to suggest that our results are not due to an endogenous relationship between conservatism and UTM. We also find that conservatism neither encourages downward tone management (DTM) nor constrains managers from conveying real information about future good news. Together, our results suggest that accounting conservatism improves disclosure narratives.     

Valuation Implications of Unconditional Accounting Conservatism: Evidence from Analysts' Target Prices

We examine whether financial analysts understand the valuation implications of unconditional accounting conservatism when forecasting target prices. While accounting conservatism affects reported earnings, conservatism per se does not have an effect on the present value of future cash flows. We examine whether analysts adjust for the effect of conservatism included in their earnings forecasts when using these forecasts to estimate target prices. We find that signed target price errors (actual minus forecast) have a significant positive association with the degree of conservatism in forward earnings, suggesting that target prices are biased due to accounting conservatism. Cross‐sectional analysis suggests that more sophisticated analysts and superior long‐term forecasters adjust for conservatism to a greater extent than other analysts. In additional analyses, we explore the mechanism through which conservatism leads to bias in target prices. We first show that analysts' earnings forecasts are negatively associated with the degree of conservatism; that is, analysts include the effect of unconditional conservatism in their earnings forecasts. Based on alternative earnings‐based valuation models that analysts may use, our evidence suggests that analysts fail to appropriately adjust their valuation multiple for the effect of conservatism included in their earnings forecasts when using these forecasts to derive target prices. As a consequence, we find that, for extreme changes in conservatism, the bias in analysts' target prices due to conservatism leads to a distortion of market prices. The evidence highlights the concern that analysts may not appreciate the valuation implications of conservative accounting which could inhibit price discovery.     

Do Accounting Firm Consulting Revenues Affect Audit Quality? Evidence from the Pre‐ and Post‐SOX Eras

In recent years, public accounting firms have experienced a steady increase in the proportion of their revenues generated from consulting services. Although growth in consulting revenue following the Sarbanes‐Oxley Act (SOX) has been generated primarily from services provided to nonaudit clients, regulators have expressed concerns about the potential implications of this increase for audit quality. In contrast, accounting firms assert that the expertise developed by their consulting professionals helps them to provide better quality audits. We examine the relation between the proportion of accounting firm consulting revenue to total revenue and audit quality and investor perceptions of audit quality. Because SOX drastically altered the source of consulting revenues for public accounting firms, we also separately examine these relations in the pre‐ and post‐SOX eras. We find evidence suggesting that before SOX, higher proportions of audit firm consulting revenues negatively impacted both audit quality and investor perceptions of audit quality. However, we do not find a statistically significant association between audit firm consulting revenues and either audit quality or investor perceptions of audit quality following SOX. Our analyses suggest that even if these relations exist following SOX, the potential economic magnitude of the effect is small.     

Economic Consequences of IFRS Adoption: The Role of Changes in Disclosure Quality*

This study adopts a two‐step approach to highlight the disclosure quality channel that drives economic consequences of IFRS adoption. This approach helps address the identification challenge noted by prior research and offers direct evidence on the role of disclosure quality. In the first step, we document the impact of the IFRS mandate on changes in disclosure quality proxied by the granularity of line item disclosure in financial statements. We find that IFRS‐adopting firms provide more disaggregated information upon IFRS adoption, such as more granular disclosure of intangible assets and long‐term investments on the balance sheet and greater disaggregation of depreciation, amortization, and nonoperating income items on the income statement. In the second step, we link the observed disclosure changes to the benefits and costs of IFRS adoption. We show that greater disaggregated information due to IFRS adoption enhances market liquidity and decreases information asymmetry, but does not affect audit fees differentially. Our evidence has implications for standard setters as they evaluate cost‐benefit trade‐offs when considering disclosure changes in the future.     

Assets and Liabilities: When Do They Exist?

In this paper, we investigate whether the current references to probability in standard setters' conceptual definitions of assets and liabilities cause individuals to believe that the probability of a future transfer of economic benefits must be above some meaningful threshold for an asset or a liability to exist—a belief that is contrary to standard setters' intent. Results of multiple experiments indicate that the majority of individuals do use a high probability threshold to determine asset existence, whereas for liabilities the majority use a very low threshold. Thus, even under ceteris paribus conditions, liabilities are more frequently judged to exist than assets—a phenomenon analogous to accounting conservatism, as has been discussed in terms of the performance statement. These findings are robust to variation in formal training and in type of liability, and cannot be explained by alternative approaches to judging existence. Consistent with standard setters' intentions, results also suggest that their proposed changes to the definitions of assets and liabilities—changes that attempt to clarify the intended role of probability—do cause a greater proportion of participants to indicate that the relevant financial statement element (asset or liability) exists, relative to participants with no definition. Our study provides important insights for standard setters as they continue work on their missions to update their Conceptual Frameworks and for researchers regarding the role of conservatism on the balance sheet.     

Did the PCAOB's 2009 Office Expansion Improve Audit Quality?*

We investigate whether the PCAOB's decision to expand the number and location of its inspection offices in 2009 improved the reliability of US audits. We use a difference-in-differences empirical design to consider the impacts of the expansion on audit quality and find that audit quality significantly improved following the PCAOB's expansion in markets where new offices opened relative to markets without an office opening. We find that the improvement in audit quality appears to be driven by auditors' reaction to real changes in PCAOB oversight and that triennially inspected auditors appear to be impacted the most by this office expansion. Our findings provide new insights into the PCAOB's operational decision-making and suggest that the regulator's additional investment in audit oversight was effective in improving audit quality.     

Hedge Fund Intervention and Accounting Conservatism

Hedge fund intervention has been associated with many positive corporate changes and is an important vehicle for informed shareholder monitoring. Effective monitoring has also been positively associated with accounting conservatism. Building upon these prior results, we predict an increase in accounting conservatism after hedge fund intervention. We use a large sample of hedge fund activist events and identify control firms with similar likelihoods of being targeted using the propensity score matching method to apply difference‐in‐difference tests. We find that when hedge fund activists have relatively large ownership and sufficient time to exert their monitoring power, target firms experience significant increases in conditional conservatism. CFO turnovers, upward/lateral auditor switches, and improvements in audit committee independence after intervention are accompanied by greater increases in conditional conservatism. Finally, we find greater increases in conditional conservatism when there is a lack of monitoring by dedicated institutional investors before the intervention. Our study suggests that hedge fund activists improve accounting monitoring tools and thus adds important new evidence on the effectiveness of shareholder monitoring on accounting practices.     

The Investment Opportunity Set and Acquired Goodwill*

This paper examines how managers in New Zealand allocate the cost of firms' investments in subsidiaries between net tangible assets and acquired goodwill. We find a negative relation between acquired goodwill and leverage. This could be interpreted as the result of managers of highly leveraged acquiring firms opportunistically allocating a lower portion of the acquisition price to acquired goodwill. However, this analysis, like much of the research on accounting choice, suffers from an omitted variables problem. We present evidence that the observed negative relation between acquired goodwill and leverage may stem from each variable's relation to the investment opportunity set. Further, we find no evidence that acquired goodwill is related to the existence of debt covenants. Together, these results suggest an endogenous relation between the firm's asset structure, its financing policy, and the allocation of acquisition price to acquired goodwill.     

The emergence and performance of the Chinese merger market and the impact of partner location

Chinese acquirers spent $38 million on mergers and acquisitions in 1990, and $666.1 billion on mergers and acquisitions in 2016. As the Chinese merger market has grown, so too has the literature on its performance. Little is known, however, about with whom Chinese firms can best do business. We aim to fill this gap. We suggest that because the liabilities of distance, foreignness, and outsideness complicate acquisition performance, targets in countries and regions which add fewer of these liabilities will outperform those that add more. We plot the overseas expansion of Chinese acquirers, and compare the performance of Chinese acquisitions, within the Greater China region, within the Confucian cultural sphere, and between Asian and the West. In each case, we predict that increasing cultural distance decreases performance. Then, because the Continental European governance system is institutionally more familiar to the Chinese system than it is to the Anglo-Saxon system, we consider the Chinese experience in each of these two systems. Our results largely support our hypotheses built on the partner location performance hierarchy argument, but we also point to the limits of the generalizability of existing literature in understanding the Chinese market.     

M&A Due Diligence,Post‐Acquisition Performance,and Financial Reporting for Business Combinations

Before completing merger and acquisition (M&A) transactions, acquiring firms conduct due diligence. This process provides acquiring firms with a more informed assessment of the expected costs, benefits, and risks of an acquisition and offers one last opportunity to renegotiate or terminate an M&A transaction. However, acquiring firms must trade off the costs and benefits of performing additional due diligence versus completing the acquisition. Based on an analysis of the time to negotiate the acquisition agreement and complete the transaction, I predict and find that competitive pressures, short‐term financial reporting incentives, and agency problems are associated with less due diligence. I also find that less due diligence is associated with lower post‐acquisition profitability, a higher probability of acquisition‐related goodwill impairments, and lower quality fair value estimates for the acquired assets and liabilities. These findings highlight due diligence as an important factor explaining cross‐sectional variation in post‐acquisition performance and financial reporting for business combinations.     

Investor Sentiment,Misstatements, and Auditor Behavior*

High investor sentiment has been linked with opportunistic managerial behavior in the face of more optimistic investors and analysts. We extend this line of work by documenting that the likelihood of misstatements is higher when sentiment is high. Although this would suggest elevated audit risk, we posit that a contemporaneous reduction in auditors' litigation cost could drive down audit fees and going concern opinion (GCO) reporting conservatism in order to please clientele. Consistent with this notion, we document that auditors charge lower fees and report GCOs less conservatively when sentiment is high. However, this reduction in reporting conservatism is unwarranted; results reveal that auditors are less likely to issue GCOs to clients which subsequently file for bankruptcy during high sentiment periods. We conduct additional tests to examine whether auditors' litigation costs indeed vary with sentiment and document that auditors are less likely to be sued and the market reacts less negatively to misstatement announcements when sentiment is high. Collectively, our findings suggest that, although misstatement risk is increasing with sentiment, auditors' litigation risk actually declines.     

An Empirical Analysis of Analysts' Capital Expenditure Forecasts: Evidence from Corporate Investment Efficiency*

We examine whether the information conveyed in a relatively new analyst research output—capital expenditure (capex) forecasts—affects corporate investment efficiency. We find that firms with analyst capex forecasts exhibit higher investment efficiency. This effect is stronger when the forecasts are issued by analysts with higher ability or greater industry knowledge. Moreover, the effect of capex forecasts on investment efficiency varies with the signals they convey about future growth opportunities—positive-growth signals are more effective in reducing underinvestment, while negative-growth signals are more effective in reducing overinvestment. Cross-sectional tests suggest that these effects operate at least in part through both a financing channel and a monitoring channel. Taken together, our results suggest that analysts' capex forecasts convey useful information about firms' growth opportunities to managers and investors, which can facilitate efficient investment.     

Shareholder Empowerment and Board of Directors Effectiveness*

We develop a model to examine implications of empowering shareholders to replace directors. We find that shareholder empowerment functions as a double-edged sword. On the one hand, it can weaken ineffective boards' incentive to hold on to their position. On the other hand, it can induce both effective and ineffective boards to behave strategically to avoid a potential dismissal. As a result, empowerment does not necessarily increase firm value; in some cases, empowerment exacerbates the agency problem it is intended to address. Giving shareholders the power to set board compensation (have a “say on pay”) can mitigate these problems. However, even when empowerment benefits (harms) the shareholders, firm value may decrease (increase). Finally, we discuss empirical and policy implications of the main findings.