PCAOB Inspections: Public Accounting Firms on “Trial”

The objective of our article is to obtain a better understanding of how auditors anticipate the potential for PCAOB inspection, experience the inspection, cope with the consequences of the inspection, and understand the PCAOB's influence within the context of professionalism. We use a qualitative approach that uses both surveys (55) and interviews (20) of auditors (of varying rank and firm) across a five‐year period (2012–2017). Respondents suggest that PCAOB inspectors are powerful, representing the “prosecution,” “judge,” and “jury” of the auditing profession. We therefore use a structural metaphor of the PCAOB inspection as a judicial “trial.” By controlling the criteria used to evaluate performance, inspectors have the power to repeatedly “subpoena,” “interrogate,” and return a “verdict” on the firm (auditor); those judged as “guilty” require supervised “probation.” This process is perceived as having improved audit quality but at a cost. Passing an inspection is so important that auditors (firms) have resorted to impression management strategies and “functionally stupid” work practices (e.g., excessive documentation, a decrease in critical thinking as a result of a “box ticking” approach to auditing). Furthermore, some respondents believe that being a good auditor has come at the expense of being a good accountant; the emphasis on audit process and concurrent de‐emphasis on technical accounting could ultimately lead to audits themselves falling short. In addition, it is evident that inspectors and auditors differ in their perceptions of risk, likely manifesting because inspectors are standards‐focused while auditors (firms) are methodology‐focused. Finally, the inspection process has created excessive stress and tension, beyond budget and fee pressures, which some auditors perceive as affecting the pool of talented auditors that firms may be able to attract and retain in the future.     

The Effect of Homework on Exam Performance: Experimental Results from Principles of Economics

We assess the effect of the completion of online homework assignments on exam performance in “Principles of Economics” using a unique experimental method. For specific homework assignments we randomize students into two groups: those for whom the assignment is optional and those for whom it is required. This randomization, which affects incentives to complete the homework assignment for a particular topic, generates an instrument that helps identify the effect of homework completion on topic‐specific exam performance. Results of the instrumental variables analysis, as well as results of a variety of other analyses, indicate that the completion of the assigned homework is positively (if not always significantly) correlated with higher scores on the midterms but not on the final exam—indicating “decay” in the homework effect over the course of the semester.     

Accounting Discretion and Managerial Conservatism: An Intertemporal Analysis*

Accounting discretion and the principle of conservatism are two salient features embedded in financial reporting systems. Arguably, the practice of conservative accounting choices can never be well understood without incorporating their effect on future periods (the intertemporal effect). This paper provides one explanation for managerial conservatism in a two‐period agency model with hidden information (a binary project type) and hidden actions (the agent's efforts). A piece‐wise linear incentive scheme with accounting earnings as the performance measure is employed. The agent's discretion is the choice of a depreciation method. Discretion is valuable if and only if the agent's marginal productivity of a “bad” project is greater than that of a “good” project, but not to an extreme degree. A conservative depreciation method decreases current compensation in exchange for a “bet” on future compensation and, hence, serves as a commitment device for the agent to signal that the prospect is indeed good. The accounting mechanism replicates the performance of the optimal direct mechanism.     

Financing China’s cotton textile industry: 1890–1936

The cotton textile industry was the primary source of Britain’s industrial revolution and Japan’s economic takeoff. The Chinese domestic mechanized cotton textile industry experienced a boom during the interwar period and became the leading industry in the manufacturing sector, although it failed to gain domestic leadership against Japanese funded firms. There is a debate on the role of external finance on firm growth both in the contemporary context and historical cotton textile industry context. The literature offers several competing hypotheses on the relationship between capital and industry growth such as “modernization”, “oppression” and “efficiency” argument. Our empirical results using firm level data between return of capital and the size of the capital indicate a clear positive effect of external finance on firm growth. This supports the “modernization” hypothesis and suggests that the causes of the mediocre performance of the Chinese-owned spinners relative to Japanese mills may have been mismanagement, undercapitalization, lack of reinvestment incentives, and low labor productivity etc.     

Competitiveness and Subsidy or Tax Policy for New Technology Adoption in Duopoly

We consider a problem of subsidy or tax policy for new technology adoption by duopolistic firms. The technology is developed in and transferred by a foreign country to the domestic country. It is free but each firm must expend some fixed set-up cost for education of its staff to adopt and use it. Assuming that each firm maximizes the weighted average of absolute and relative profits, we examine the relationship between competitiveness and subsidy or tax policies for technology adoption, and show that when firm behavior is not competitive (the weight on the relative profit is small), the optimal policy of the government may be taxation; when firm behavior is competitive (the weight on the relative profit is large), the optimal policy is subsidization or inaction and not taxation. However, if firm behavior is extremely competitive (close to perfect competition), taxation case re-emerges.     

South–South FDI: is it really different?

We compare the performance of Northern and Southern multinationals in Sub-Saharan Africa, and contrast it with local firms in the host country. Employing unique firm level data for 19 Sub-Saharan African countries, we show that firms receiving FDI outperform domestic ones, while the origin of the foreign investor is of minor importance. We use three different definitions of “South” to compare Northern and Southern FDI. Overall, we do not find strong differences in terms of firm productivity growth between Northern and Southern FDI, irrespective of how the latter is defined. However, we find that employment growth is generally higher for firms receiving FDI from other African investors as compared to Northern FDI, and they also receive more technology transfer from their parent company abroad.     

Market Performance Implications of the Transfer Price Rule

The “transfer price rule” (TPR) defines a vertical price squeeze as an input price, output price combination set by a vertically‐integrated firm monopoly producer of an essential input that would not allow the firm's downstream unit to earn at least a normal rate of return on investment in the “as‐if” case that it had to purchase the input at the price charged independent firms. In its 2009 linkLine decision, the U.S. Supreme Court rejected the TPR for the purpose of enforcing the anti‐monopolization prohibition of Section 2 of the Sherman Act. In contrast, a vertical price squeeze, defined by a TPR‐like standard, is an abuse of a dominant position under Article 102 of the Treaty on the Functioning of the European Union. In this article, we model the impact of the TPR on market performance. We find that the TPR increases consumer surplus and net social welfare if all firms remain active in the downstream market. It sometimes induces the upstream firm to refuse to supply the downstream firm, and in such cases, consumer surplus and net social welfare are reduced. The impact of the TPR on market performance thus depends on whether or not an upstream firm can refuse to supply downstream firms on terms that would offer it at least a normal rate of return on investment.     

A choice‐theoretic analysis of a corporate tax holiday versus a subsidy

This paper attempts to compare the effect of a corporate tax holiday with that of a subsidy on the behaviour of the individual firm. Assuming the subsidy equals the amount of tax paid by a firm operating under the subsidy system, we find that the firm's net profit will be greater under the tax holiday than under the subsidy regime. Similarly, if the subsidy exceeds the tax by an amount that would equalize the profits made by the (“marginal”) firm under the two regimes, then it is found that firms with higher than “average” unit costs would opt for the subsidy system; conversely, firms with a low cost structure would maximize profits by selecting the tax holiday. Finally, a multiperiod analysis of the particular choice facing prospective manufacturers in Ciskei, shows that the firm would normally choose the subsidy system except if the current tax exceeded the subsidy at the output level representing maximum profit under the tax holiday.     

Director Monitoring of Expense Misreporting in Nonprofit Organizations: The Effects of Expense Disclosure Transparency,Donor Evaluation Focus and Organization Performance

This study examines whether three factors—the transparency of expense disclosures, donor evaluation focus, and organization performance—influence how directors monitor management expense misreporting in nonprofit organizations. An experiment with 189 nonprofit directors finds that the enhanced transparency of expense disclosures increases director monitoring by reducing the tendency to accept management expense misreporting. Further, an organization's nonfinancial performance and the perceived fairness of donor evaluation focus interact to influence director monitoring practices. Specifically, when directors know an organization's nonfinancial performance is poor and understand that this performance will negatively influence the willingness of donors to contribute, directors monitor less if they think that donors are adopting a more balanced approach to organizational evaluation that focuses on both financial and nonfinancial performance; that is, there is a reverse fair process effect as this donor approach is perceived as being fairer than if donors focus solely on financial performance. However, monitoring is equally strong regardless of donor evaluation focus when directors know that an organization's nonfinancial performance is good and a donation is forthcoming.     

Are Related Party Transactions Red Flags?

This study investigates whether or not related party transactions serve as “red flags” that warn of potential financial misstatement. We hand‐collect related party transactions for S&P 1500 firms in 2001, 2004, and 2007 and find a positive correlation between these transactions and future restatements, suggesting restatements are more likely when a firm engages in related party transactions. The association is concentrated among transactions that appear to reflect “tone at the top” rather than arguably more necessary business transactions. We also find RPT firms pay lower audit fees. However, “tone RPT” firms that subsequently restate pay higher audit fees, providing evidence that auditors recognize the individual restatement risks of these firms. Our results suggest that tone‐based RPTs serve as signals of higher risk of material misstatement.     

The Role of Innovation in the Postentry Performance of New Small Firms: Evidence from Italy

The purpose of this paper is to relate the start-up decision to the postentry performance of new small firms. We use a database of 147 newly founded Italian firms that have spun-off from existing firms. The quantitative questionnaire analysis studied the relationship between the original factors shaping the decision to start a new firm, including learning in the “mother” firm, and the postentry performance of the new initiatives. The evidence suggests that innovative motivation, innovative learning, and a higher managerial position in the original mother firm tend to be related to a superior postentry performance.     

A comparison of shareholder identity and governance mechanisms in the monitoring of CEOs of listed companies in China

This paper compares the relative effectiveness of two measures by which the Chinese government attempted to improve the monitoring of listed companies: shifting the ownership of state shares from government agencies (GAs) to the corporate form of state-owned enterprises (SOEs), and strengthening corporate governance through statutory regulations and guidelines. The results show that SOEs are better able than GAs to monitor top executives, as indicated by a higher sensitivity of top executive turnover to firm performance. However, corporate governance mechanisms have no significant impact on the sensitivity of top executive turnover to firm performance. This study suggests that incentives for controlling shareholders are more important than governance mechanisms in replacing executives due to poor performance in a transitional economy such as China's, where institutions that support governance mechanisms are still being developed.     

Resource Allocation Effects of Price Reactions to Disclosures*

Capital market participants collectively may possess information about the valuation implications of a firm's change in strategy not known by the management of the firm proposing the change. We ask whether a firm's management can exploit the capital market's information in deciding either whether to proceed with a contemplated strategy change or whether to continue with a previously initiated strategy change. In the case of a proposed strategy change, we show that managers can extract the capital market's information by announcing a potential new strategy, and then conditioning the decision to implement the new strategy on the size of the market's price reaction to the announcement. Under this arrangement, we show that a necessary condition to implement all and only positive net present value strategy changes is that managers proceed to implement some strategies that garner negative price reactions upon their announcement. In the case of deciding whether to continue with a previously implemented strategy change, we show that it may be optimal for the firm to predicate its abandonment/continuation decision on the magnitude of the costs it has already incurred. Thus, what looks like “sunk‐cost” behavior may in fact be optimal. Both demonstrations show that, in addition to performing their usual role of anticipating future cash flows generated by a manager's actions, capital market prices can also be used to direct a manager's actions. It follows that, in contrast to the usual depiction of the information flows between capital markets and firms as being one way — from firms to the capital markets — information also flows from capital markets to firms.     

INTERNATIONAL PRODUCTION/DISTRIBUTION NETWORKS AND INDONESIA

This study examines the industrialization performance of Indonesia through a comparative evaluation with other East Asian economies. While neighboring countries actively formulated international production/distribution networks, Indonesia fell behind in utilizing the benefits of globalizing corporate activities. International production/distribution networks are supported by new economic thought such as fragmentation, agglomeration, and theories about corporate firm; and a policy package of development strategies should be designed to utilize such opportunities. The design of Indonesia's development strategies and “institutions”, however, does not conform to the globalizing world because the presence of network‐forming foreign companies is not large enough to make them influential “actors”. This author argues that the traditional comparative advantage argument for Indonesia's economic development is possibly misleading. Rather, Indonesia must learn the experience of its neighboring countries and introduce foreign companies as new actors to break the old “structure”.     

A 50-year history of “zombie firms” in Japan: How banks and shareholders have been involved in corporate bailouts?

We review long-term changes in “zombie firms” in Japan over this half-century using listed firm data with a framework in which the concept of “zombie firms” includes possible efficient bailouts. The first wave of zombie firms occurred during the period of main banks (hereinafter MBs). MBs were able to actively choose which firms would receive bailouts at the time. However, commonly held beliefs about MBs’ monitoring power and the special role of corporate groups and long-term credit banks for bailouts are not supported. In the largest wave of the lost decade, we find the zombie firm problem in the manufacturing sector was just as serious as the non-manufacturing in terms of firm count. Moreover, the pathological phenomena such as unwilling concentration of loans to MBs were also rather typical in the manufacturing. Soft budget constraints have continued in the manufacturing even after the resolution of banks’ non-performing loans since the bubble burst came to an end, leading to the manufacturing-centered third wave of zombie firms following the Global Financial Crisis.     

Cheating and Enforcement in Asymmetric Rank‐Order Tournaments

In rank‐order tournaments, undesirable but output‐enhancing activities, such as cheating, may occur. Cheating may be especially tempting when one player has an advantage over another. We show that when audit probabilities are low (high), the leading (trailing) player has more incentive to cheat. Furthermore, we show that “correlated” audits are more effective at decreasing the frequency of cheating than independent audits. Finally, we show that differential monitoring schemes, where contestants are audited based on either their initial position or final ranking, more efficiently achieve full deterrence than schemes that monitor contestants with equal probability.     

Performance Measure Manipulation*

A two-period model in which communication restrictions preclude the usual revelation representation is analyzed, and the communication policies take on the appearance of “income smoothing.” The driving force is the information content of the “smoothed” or manipulated series, relative to its counterpart were manipulation not possible. Various possibilities arise, depending on the underlying stochastic structure: performance measure manipulation might be socially efficient, or not; and when it is best to invite and motivate this manipulation, the optimal policy itself can take on a variety of forms.     

A Re-Examination of Financial Analysts' Differential Earnings Forecast Accuracy*

Abstract. This research re-examines whether there are differences in the forecast accuracy of financial analysts through a comparison of their annual earnings per share forecasts. The comparison of analyst forecast accuracy is made on both an ex post (within sample) and an ex ante (out of sample) basis. Early examinations of this issue by Richards (1976), Brown and Rozeff (1980), O'Brien (1987), Coggin and Hunter (1989), O'Brien (1990), and Butler and Lang (1991) were ex post and suggest the absence of analysts who can provide relatively more accurate forecasts over multiple years. Contrary to the results of prior research and consistent with the belief in the popular press, we document that differences do exist in financial analysts' ex post forecast accuracy. We show that the previous studies failed to find differences in forecast accuracy due to inadequate (or no) control for differences in the recency of forecasts issued by the analysts. It has been well documented in the literature that forecast recency is positively related to forecast accuracy (Crichfield, Dyckman, and Lakonishok 1978; O'Brien 1988; Brown 1991). Thus, failure to control for forecast recency may reduce the power of tests, making it difficult to reject the null hypothesis of no differences in forecast accuracy even if they do exist. In our analysis, we control for the differences in recency of analysts' forecasts using two different approaches. First, we use an estimated generalized least squares estimation procedure that captures the recency-induced effects in the residuals of the model. Second, we use a matched-pair design whereby we measure the relative forecast accuracy of an analyst by comparing his/her forecast error to the forecast error of another randomly selected analyst making forecasts for the same firm in the same year on or around the same date. Using both approaches, we find that differential forecast accuracy does exist amongst analysts, especially in samples with minimum forecast horizons of five and 60 trading days. We show that these differences are not attributable to differences in the forecast issuance frequency of the financial analysts. In sum, after controlling for firm, year, forecast recency, and forecast issuance frequency of individual analysts, the analyst effect persists. To validate our findings, we examine whether the differences in the forecast accuracy of financial analysts persist in holdout periods. Analysts were assigned a “superior” (“inferior”) status for a firm-year in the estimation sample using percentile rankings on the distribution of absolute forecast errors for that firm-year. We use estimation samples of one- to four-year duration, and consider two different definitions of analyst forecast superiority. Analysts were classified as firm-specific “superior” if they maintained a “superior” status in every year of the estimation sample. Furthermore, they were classified as industry-specific “superior” if they were deemed firm-specific “superior” with respect to at least two firms and firm-specific “inferior” with respect to no firm in that industry. Using either definition, we find that analysts classified as “superior” in estimation samples generally remain superior in holdout periods. In contrast, we find that analysts identified as “inferior” in estimation samples do not remain inferior in holdout periods. Our results suggest that some analysts' earnings forecasts should be weighted higher than others when formulating composite earnings expectations. This suggestion is predicated on the assumption that capital markets distinguish between analysts who are ex ante superior, and that they utilize this information when formulating stock prices. Our study provides an ex ante framework for identifying those analysts who appear to be superior. When constructing weighted forecasts, a one-year estimation period should be used because we obtain the strongest results of persistence in this case.     

Fraud Firms' Non-Implicated CFOs: An Investigation of Reputational Contagion and Subsequent Employment Outcomes*

We investigate labor market consequences for CFOs employed by fraud firms, focusing on reputational contagion for those who are not implicated. These individuals provide an opportunity to understand reputational contagion and the nuanced meaning of “guilt” because the labor market may suspect complicity or infer negligence regardless of whether that is truly the case. We compare these CFOs to a matched sample of non-fraud CFOs and track both turnover and subsequent employment positions. Non-implicated CFOs are more likely to experience turnover compared to non-fraud CFOs, driven in particular by the public revelation of fraud to the labor market. We further find that non-implicated CFOs are more likely to obtain comparable subsequent employment than non-fraud CFOs before the fraud is publicly revealed, but not after. In supplementary analyses, we find that turnover rates are highest for non-implicated CFOs who started their employment with the firm before the fraud began as compared to non-implicated CFOs who started their employment after the fraud began. These results highlight the labor market significance of the public revelation of fraud and imply that the labor market does not fully distinguish between fraud firm association and general firm performance when making executive hiring decisions.     

Dynamics of Firm-Supplier Relationships in a Less Developed Economy: Evidence from African Manufacturing Firms

In this paper, we study supplier-firm interactions to explain firms' outsourcing relationships. We show that in an imperfect information setup a firm learns about the quality of its suppliers through repeated interaction. As the firm determines the suppliers' quality with greater precision, it gives a greater proportion of its contracts to these “better” suppliers. We report evidence from African manufacturing firms that is consistent with our hypothesis: both frequency and volume of transactions increase with the length of a firm's relationship with its supplier. These effects are stronger in poor contracting environments.