Overconfidence and tax avoidance: The role of CEO and CFO interaction

We investigate how overconfident CEOs and CFOs may interact to influence firms’ tax avoidance. We adopt an equity measure to capture overconfident CEOs and CFOs and utilize multiple measures to identify companies’ tax-avoidance activities. We document that CFOs, as CEOs’ business partners, play an important role in facilitating and executing overconfident CEOs’ decisions in regard to tax avoidance. Specifically, we find that companies are more likely to engage in tax-avoidance activities when they have both overconfident CEOs and overconfident CFOs, compared with companies that have other combinations of CEO/CFO overconfidence (e.g., an overconfident CEO with a non-overconfident CFO), which is consistent with the False Consensus Effect Theory. Our study helps investors, regulators, and policymakers understand companies’ decision-making processes with regard to tax avoidance.     

Financial expert CEOs: CEO׳s work experience and firm׳s financial policies

We study CEOs with a career background in finance. Firms with financial expert CEOs hold less cash, more debt, and engage in more share repurchases. Financial expert CEOs are more financially sophisticated: they are less likely to use one companywide discount rate instead of a project-specific one, they manage financial policies more actively, and their firm investments are less sensitive to cash flows. Financial expert CEOs are able to raise external funds even when credit conditions are tight, and they were more responsive to the dividend and capital gains tax cuts in 2003. Analyzing CEO-firm matching based on financial experience, we find that financial expert CEOs tend to be hired by more mature firms. Our results are consistent with employment histories of CEOs being relevant for corporate policies. However, we cannot formally rule out that our findings are partly explained by endogenous CEO-firm matching.     

Overconfidence and Corporate Tax Policy

Review of Accounting Studies - Using a sample of firms experiencing exogenous CEO departures, we investigate whether firms with overconfident CEOs avoid more tax. We find robust evidence of a...     

Information processing costs and corporate tax avoidance: Evidence from the SEC’s XBRL mandate

The IRS uses information contained in financial statements as well as tax returns to detect tax avoidance behavior. We examine the impact on corporate tax avoidance behavior of reductions in the IRS’s information processing costs resulting from the mandatory adoption of XBRL for financial reporting. Motivated by the recent debate in the U.S. Congress over the cost-benefit of mandatory XBRL reporting for small firms, we pay particular attention to small firms, which inherently have relatively high information frictions. We find that the adoption of XBRL for financial reporting results in a significant decrease in tax avoidance. We further find that the negative relation between XBRL reporting and tax avoidance is less prominent for firms subject to more intense IRS monitoring in the pre-XBRL-reporting period. Overall, our results suggest that XBRL reporting reduces the cost of IRS monitoring in terms of information processing, which dampens managerial incentives to engage in tax avoidance behavior.     

Taxes and Financial Constraints: Evidence from Linguistic Cues

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.     

IRS Attention

We study how public and private disclosure requirements interact to influence both tax regulator enforcement and firm disclosure. To capture IRS enforcement activities, we introduce a novel data set of IRS acquisition of firms’ public financial disclosures, which we label IRS attention. We examine the implementation of two new disclosure requirements that potentially alter IRS attention: FIN 48, which increased public tax disclosure requirements, and Schedule UTP, which increased private tax disclosure. We find that IRS attention increased following FIN 48 but subsequently decreased following Schedule UTP, consistent with public and private disclosure interacting to influence tax enforcement. We next examine how private tax disclosure requirements under Schedule UTP affected firms’ public disclosure responses. We find that, following Schedule UTP, firms significantly increased the quantity and altered the content of their tax‐related disclosures, consistent with lower tax‐related proprietary costs of disclosure. Our results suggest that changes in SEC disclosure requirements altered the IRS's behavior with regard to public information acquisition, and, relatedly, changes in IRS private disclosure requirements appear to change firms’ public disclosure behavior.     

CEO overconfidence and bank loan contracting

In this paper, we examine the effect of managerial overconfidence on bank loan spreads. Our theoretical model and empirical results support that firms with highly overconfident CEOs have lower loan spreads and that the reducing effect of these CEOs on the spread is more pronounced when the loan contracts have collateral or covenants. Unlike firms with highly overconfident CEOs, firms with moderately overconfident CEOs do not receive lower loan spreads. We perform various tests to alleviate the concerns about endogeneity, and the results are robust. The results are consistent with the idea that highly overconfident CEOs are more willing to pledge collateral and accept covenants in exchange for a reduction in their loan rate.     

Financial Expert CEOs and Earnings Management Around Initial Public Offerings

This study examines the association between financial expert CEOs and earnings management (EM) around initial public offerings. We identify financial expert CEOs as those having past experience in either banking or investment firms, large auditing firms, or finance-related roles. We find strong evidence that newly listed firms with financial expert CEOs are less likely to engage in either accrual-based or real EM in the offering year than those with non-financial expert CEOs. In particular, our results are robust after controlling for the potential selection issue that occurs due to non-random matching of CEOs to firms. In addition, we employ alternative measures of financial expertise, including past experience in a CFO position, financial experience variety, and professional qualifications. We document that CEOs who used to work as CFOs and those who gained varied financial experience are less likely to manage earnings through both accruals and real activities. Moreover, CEOs who have a professional qualification in finance and/or accounting are also associated with lower accrual-based EM.     

Are overconfident CEOs better leaders? Evidence from stakeholder commitments

We find evidence that the leadership of overconfident chief executive officers (CEOs) induces stakeholders to take actions that contribute to the leader's vision. By being intentionally overexposed to the idiosyncratic risk of their firms, overconfident CEOs exhibit a strong belief in their firms’ prospects. This belief attracts suppliers beyond the firm's observable expansionary corporate activities. Overconfident CEOs induce more supplier commitments including greater relationship-specific investment and longer relationship duration. Overconfident CEOs also induce stronger labor commitments as employees exhibit lower turnover rates and greater ownership of company stock in benefit plans.     

CEO overconfidence and dividend policy

We develop a model of the dynamic interaction between CEO overconfidence and dividend policy. The model shows that an overconfident CEO views external financing as costly and hence builds financial slack for future investment needs by lowering the current dividend payout. Consistent with the main prediction, we find that the level of dividend payout is about one-sixth lower in firms managed by CEOs who are more likely to be overconfident. We document that this reduction in dividends associated with CEO overconfidence is greater in firms with lower growth opportunities and lower cash flow. We also show that the magnitude of the positive market reaction to a dividend-increase announcement is higher for firms with greater uncertainty about CEO overconfidence.     

Terrorist attacks and corporate investment: The beneficial value of CEO overconfidence

This study examines whether terrorist attacks influence corporate investments and firm value. We expect that overconfident CEOs can mitigate the underinvestment problem caused by terrorist attacks because they overestimate the returns on investment. Using measures of terrorist attack proximity in the U.S., we find that firms with non-overconfident CEOs significantly decrease their investment growth when terrorist attacks affect them, while firms with overconfident CEOs do not. Consequently, the impact of terrorist attacks on firm value varies between firms with overconfident and non-overconfident CEOs. Overall, this study suggests that CEO overconfidence can benefit shareholder value under certain conditions, such as terrorist attacks.     

Economic policy uncertainty and firm tax avoidance

We find strong evidence that firms reduce cash effective tax rate when economic policy uncertainty heightens. Firms also engage in more aggressive forms of tax avoidance including long-term tax planning or shelters. Cash holdings attenuate the negative effect of policy uncertainty on cash effective tax rate, especially for financially constrained firms. The cash tax savings are retained for reinvestments rather than dividend payouts. Our findings suggest that policy uncertainty exacerbates external financing frictions, which in turn induces precautionary motives of tax avoidance.     

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

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

The effects of board gender diversity on a firm's risk strategies

We study whether board gender diversity (BGD) affects corporate risk strategies. Specifically, we investigate the association between BGD and firms’ reputation risk and financial risk. Using S&P data from 1997 to 2013, we find that BGD is negatively associated with tax avoidance, suggesting firms with gender‐diverse boards are more cautious about potential reputation risks associated with aggressive tax strategies. However, we find that BGD is positively associated with firms’ financial risk. The combined findings illustrate that BGD aligns a firm's risk exposure closer to risk‐neutral shareholders’ preferences by reducing reputation risk exposure while enabling necessary financial risk exposure.     

CEO Overconfidence and Corporate Investment

We argue that managerial overconfidence can account for corporate investment distortions. Overconfident managers overestimate the returns to their investment projects and view external funds as unduly costly. Thus, they overinvest when they have abundant internal funds, but curtail investment when they require external financing. We test the overconfidence hypothesis, using panel data on personal portfolio and corporate investment decisions of Forbes 500 CEOs. We classify CEOs as overconfident if they persistently fail to reduce their personal exposure to company‐specific risk. We find that investment of overconfident CEOs is significantly more responsive to cash flow, particularly in equity‐dependent firms.     

Retail investor attention and corporate innovation in the big data era

This paper explores the corporate governance role of retail investor attention from the perspective of corporate innovation. Using a sample of Chinese listed firms from 2011 to 2019, we find that retail investor attention significantly promotes corporate innovation. Thisresult ise robust to a series of robustness checks to address potential endogeneity concerns. I further conclude that the impact of retail investor attention on corporate innovation is mainly through alleviating a firm's financial constraints and deterring agency costs. In addition, such effects are more pronounced in firms with higher media and analyst coverage as well as those with more overconfident CEOs. The results provide empirical evidence of the corporate governance function of individual investors in the current digital era.     

Audit committee characteristics and financial statement comparability

Financial statement comparability enables weighing the similarities and differences in financial performance between firms. Prior studies mainly focus on the role of accounting standards in the production of comparability, but the role of economic agents has been largely overlooked. We find that a firm's audit committee size and financial expertise affect its financial statement comparability. Financial information tends to be more comparable among industry peers when audit committees are larger and more members have financial and accounting expertise. The effect of audit committee expertise on comparability is stronger for firms with less independent and smaller boards, for firms with non-Big 4 auditors and for firms with CEOs serving as the chairperson of the boards.     

How do CEO incentives affect corporate tax planning and financial reporting of income taxes?

We examine how different accounting metrics used to evaluate CEO performance for annual bonuses affect the level of corporate tax planning as well as financial reporting for income taxes. We predict and find that firms using cash flow metrics report lower GAAP and cash effective tax rates (ETR) than firms using earnings metrics. We also find that firms using after-tax earnings metrics report lower GAAP ETRs but similar cash ETRs as firms using pre-tax earnings metrics. Further analyses show that firms using after-tax earnings metrics are more likely to designate foreign earnings as permanently reinvested and have lower discretionary reserves for tax uncertainty. Hence, it appears that both types of firms engage in similar levels of tax planning, but firms evaluating CEOs with after tax-earnings metrics incentivize different financial reporting choices.     

Can CEO dismissals be proactive?

We find significant variation in the prior stock returns of firms that dismiss their CEOs between 1996 and 2008. 49% of firms that dismiss their CEOs do so in the absence of negative industry-adjusted stock returns prior to dismissal (37% dismiss in the absence of negative raw returns). We find evidence for two reasons why boards may dismiss CEOs early, i.e., in the absence of significant poor prior stock performance. First, we find that early dismissals are more likely to be associated with corporate scandals, suggesting that CEOs that are found to engage in unethical or illegal activities are dismissed although their actions may not have a significant adverse impact on firm value. Second, we find support for the argument that early dismissals are proactive actions by boards to dismiss low ability CEOs. We find that firms with more equity-based compensation for directors and higher independent director ownership are more likely to dismiss their CEOs early. Boards with strong incentives are more likely to be proactive and act on their private information about the CEO than boards with poor incentives. Early dismissal firms experience a short-lived decline in operating performance around the date of CEO dismissal, and their operating performance recovers immediately after the CEO is replaced. On the other hand, the operating performance of late dismissal firms declines significantly prior to dismissal and improves substantially after dismissal. We also find that CEOs that are dismissed early are not more likely to find new CEO positions than CEOs that are dismissed late, supporting the idea that early dismissal CEOs may not have different ability than late dismissal CEOs.     

Birds of a feather flock together: Institutional investors with disciplinary history and financial reporting

This study examines the role of financial misconduct of institutional investors on financial reporting quality of investee firms. We find that the firms held by institutional investors with disciplinary history (IDH) are more likely to engage in financial misreporting. Our results are not driven by institutional investor characteristics such as activism, incentives to monitor, investment horizon, or portfolio size. The impact of IDH is stronger in the firms that are more likely to engage in financial misreporting (i.e., the firms that barely meet analysts’ expectations and with CEOs with higher career concerns). IDH have stronger impact on financial misreporting when the institution reports multiple disciplinary events, the disciplinary event is recent, or disciplinary action is taken against the institutional investor company rather than just its affiliates. Results continue to hold after implementing various statistical tests to address potential endogeneity issues and alternative measures of financial misreporting.