The consequences to managers for financial misrepresentation

We track the fortunes of all 2,206 individuals identified as responsible parties for all 788 Securities and Exchange Commission (SEC) and Department of Justice (DOJ) enforcement actions for financial misrepresentation from January 1, 1978 through September 30, 2006. Fully 93% lose their jobs by the end of the regulatory enforcement period. Most are explicitly fired. The likelihood of ouster increases with the cost of the misconduct to shareholders and the quality of the firm's governance. Culpable managers also bear substantial financial losses through restrictions on their future employment, their shareholdings in the firm, and SEC fines. A sizeable minority (28%) face criminal charges and penalties, including jail sentences that average 4.3 years. These results indicate that the individual perpetrators of financial misconduct face significant disciplinary action.     

IFRS adoption in Europe and investment-cash flow sensitivity: Outsider versus insider economies

We examine the economic consequences of the mandatory adoption of IFRS in EU countries by showing which types of economies have the largest reduction in investment-cash flow sensitivity post-IFRS. We also examine whether the reduction in investment-cash flow sensitivity depends on firm size as well as economy type.We find that the investment-cash flow sensitivity of insider economies is higher than that of outsider economies pre-IFRS and that IFRS reduces the investment-cash flow sensitivity of insider economies more than that of outsider economies. Also, we find that small firms in insider economies have the highest sensitivity of investment to lagged cash flow pre-IFRS, and that they are no longer sensitive to lagged cash flow post-IFRS. Overall, our results suggest that IFRS adoption might have improved the functioning of capital markets in relation to small firms in insider economies.     

Earnings expectations and the quality of financial services

Using complaint data filed by consumers with the Consumer Financial Protection Bureau against financial institutions, we show that banks receive, on average, 13.3% more customer complaints in the quarter immediately after they narrowly beat analysts’ earnings forecasts. The effect is mainly driven by banks’ attempts to reduce their non-interest expenses to beat earnings benchmarks. The relationship is stronger when bank CEOs receive a greater proportion of incentive-based compensation. Overall, our paper demonstrates how capital market incentives exacerbate shareholder–customer conflicts.     

The economics of conflicts of interest in financial institutions

A conflict of interest exists when a party to a transaction can gain by taking actions that are detrimental to its counterparty. This paper examines the growing empirical literature on the economics of conflicts of interest in financial institutions. Economic analysis shows that, although conflicts of interest are omnipresent when contracting is costly and parties are imperfectly informed, there are important factors that mitigate their impact and, strikingly, it is possible for customers of financial institutions to benefit from the existence of such conflicts. The empirical literature reaches conclusions that differ across types of conflicts of interest but are overall more ambivalent and certainly more benign than the conclusions drawn by journalists and politicians from mostly anecdotal evidence.     

Why do corporate managers misstate financial statements? The role of option compensation and other factors

We investigate the incentives that led to the rash of restated financial statements at the end of the 1990s market bubble. We find that the likelihood of a misstated financial statement increases greatly when the CEO has very sizable holdings of in-the-money stock options. Misstatements are also more likely for firms that are constrained by an interest-coverage debt covenant, that raise new debt or equity capital, or that have a CEO who serves as board chair. Our results indicate that agency costs increased [Jensen, M.C., 2005a, Agency costs of overvalued equity. Financial Management 34, 5–19] as substantially overvalued equity caused managers to take actions to support the stock price.     

Do managers intentionally use repurchase tender offers to signal private information? Evidence from firm financial reporting behavior

Signaling is the most commonly cited explanation for stock repurchases in the academic literature. Yet, there is little evidence on whether managers intentionally use repurchases as signaling devices. Using a firm's financial reporting behavior to infer managerial intent, we find evidence suggesting that managers intentionally use fixed-price repurchase tender offers to signal undervaluation. In contrast, we find no evidence that managers use Dutch-auction tender offers to signal undervaluation. Instead, firms engaging in Dutch-auction repurchases act as if they are trying to deflate their earnings prior to the repurchases to further reduce the repurchasing price.     

Seasoned equity offerings: Quality of accounting information and expected flotation costs

Flotation costs represent a significant loss of capital to firms and are positively related to information asymmetry between managers and outside investors. We measure a firm's information asymmetry by its accounting information quality based on two extensions of the Dechow and Dichev [2002. The quality of accruals and earnings: the role of accrual estimation errors. Accounting Review 77, 35–59] earnings accruals model, which is a more direct approach to assessing the information available to outside investors than the more commonly used proxies. Our main hypothesis is that poor accounting information quality raises uncertainty about a firm's financial condition for outside investors, though not necessarily for insiders. This accounting effect lowers demand for a firm's new equity, thereby raising underwriting costs and risk. Using a large sample of seasoned equity offerings (SEOs), we show that poor accounting information quality is associated with higher flotation costs in terms of larger underwriting fees, larger negative SEO announcement effects, and a higher probability of SEO withdrawals. These results are robust to joint determination of offer size and flotation cost components and to adjustments for sample selection bias.     

Internal corporate governance,CEO turnover,and earnings management

The likelihood and speed of forced CEO turnover – but not voluntary turnover – are positively related to a firm's earnings management. These patterns persist in tests that consider the effects of earnings restatements, regulatory enforcement actions, and the possible endogeneity of CEO turnover and earnings management. The relation between earnings management and forced turnover occurs both in firms with good and bad performance, and when the accruals work to inflate or deflate reported earnings. These results indicate that boards tend to act proactively to discipline managers who manage earnings aggressively, before the manipulations lead to costly external consequences.     

Information Content of Internal Control Weaknesses: The Evidence from Japan

This paper investigates how capital markets in a code-law country, Japan, react to the disclosure of internal control weaknesses (ICW). The Japanese government attempted to implement a more concise, efficient, and, thus, less strict internal control reporting system than Section 404 of the US-SOX. In fact, for the first two years, the disclosure rate of ICW has been much lower in Japan than in the U.S. While market reactions to the disclosure of ICW are not significantly different from zero in our event study analysis, they become significantly negative after controlling for other information released around the disclosure date, audit quality, and other firm attributes. Our results are consistent with the notion that the disclosure of ICW is informative to the market because it is less frequent and exceptional in Japan.     

Earnings quality effect of state antitakeover statutes

Existing theories suggest two opposite effects that antitakeover protection may have on earnings management: the exacerbating effect and the mitigating effect. We use the introduction of state antitakeover laws during the mid- to late-1980s as a natural experiment to test the relationship between antitakeover protection and earnings quality. The results show that firms incorporated in states that passed the laws have lower magnitudes of abnormal accruals and higher levels of earnings informativeness in the post-passage periods, suggesting that antitakeover protection mitigates earnings management and enhances earnings quality. Further evidence shows that reductions in earnings management are concentrated in firms with low firm-level antitakeover protection and in firms with serious agency problems, and that the earnings management effect of state antitakeover laws is likely to be of short-term duration.     

Information friction and investor home bias: A perspective on the effect of global IFRS adoption on the extent of equity home bias

This paper provides a perspective on the effect of IFRS adoption on the tendency of investors to under-invest in foreign equities. We consider explanations for the equity home bias described in prior research and discuss research relevant to the informational consequences of global adoption of IFRS. Specifically, we evaluate whether IFRS adoption reduces information processing costs or decreases investor uncertainty about either the quality of financial reporting or the distribution of future cash flows. We predict that the effect of any reduction in information processing costs from the adoption of IFRS is likely to be small relative to the effects of other determinants of home bias such as the strength of investor protection mechanisms in foreign countries, behavioral biases toward familiar equities, and informational advantages related to geographical proximity. We argue that the quality of the information that investors have (or perceive they have) decreases with distance, conclude that global IFRS adoption is unlikely to affect home bias, and propose avenues for future research.     

A study of firms surrounding the threshold of Sarbanes–Oxley Section 404 Compliance

This study examines whether firms surrounding the Sarbanes–Oxley Section 404 market value compliance threshold behave opportunistically to reduce their market value to avoid compliance with Section 404. We find evidence that those firms reduce their market value temporarily during threshold measurement quarters, whereas control firms experience increasing market value. We find strong evidence of dampened stock returns and some evidence of insider trading as means to reduce the float. Additionally, we find that downward earnings management is used as a mechanism to alter investors’ expectations of firm value in order to temporarily reduce stock prices. We consider this opportunistic evidence of regulatory avoidance. Finally, we find that the likelihood of avoidance increases with the power of the CEO and decreases with the strength of the monitoring of the CEO, which suggest that avoidance is more likely to happen in firms with poor corporate governance mechanisms.     

Proactive financial reporting enforcement and shareholder wealth

Within the UK's proactive financial-reporting enforcement regime, we examine the effect of increased regulatory scrutiny on equity values. We find that a fourfold increase in the likelihood of regulator-initiated reviews of financial reports reduces equity values by 1.3% on average. Reductions in equity values are largest for firms with strong private oversight that likely ensures that they are closer to their equity-value-maximizing level of transparency. Additional evidence suggests that competition increases and that managers' investment horizons decrease in industries selected for increased regulatory scrutiny, consistent with direct compliance costs not fully explaining the reduction in equity values.     

Order aggressiveness as a metric to assess the usefulness of accounting information

Motivated by the availability of high-frequency data on trading activity, this paper proposes the use of order aggressiveness as a metric to evaluate the usefulness of accounting information. I test, through an analysis of order aggressiveness, whether earnings announcements of firms listed on the Italian Stock Exchange limit order book have information content. I estimate an ordered probit relating order aggressiveness to unexpected earnings and to three market determinants of aggressiveness. Consistent with the theory on the choice between limit and market orders, I find that order aggressiveness increases with the absolute value of unexpected earnings. The results provide evidence on the extent to which the information contained in earnings is used by traders.     

Auditor reputation and earnings management: International evidence from the banking industry

We examine the relation between auditor reputation and earnings management in banks using a sample of banks from 29 countries. In particular, we examine the implications of two aspects of auditor reputation, auditor type and auditor industry specialization, for earnings management in banks. We find that both auditor type and auditor industry specialization moderate benchmark-beating (loss-avoidance and just-meeting-or-beating prior year’s earnings) behavior in banks. In addition, we find that once auditor type and auditor industry specialization are included in the same tests, only auditor industry specialization has a significant impact on constraining benchmark-beating behavior. In separate tests related to income-increasing abnormal loan loss provisions, we find that both auditor type and auditor expertise constrain income-increasing earnings management. Again, in joint tests, only auditor industry expertise has a significant impact on constraining income-increasing earnings management.     

Accountability of independent directors: Evidence from firms subject to securities litigation

We examine which independent directors are held accountable when investors sue firms for financial and disclosure-related fraud. Investors can name independent directors as defendants in lawsuits, and they can vote against their reelection to express displeasure over the directors’ ineffectiveness at monitoring managers. In a sample of securities class action lawsuits from 1996 to 2010, about 11% of independent directors are named as defendants. The likelihood of being named is greater for audit committee members and directors who sell stock during the class period. Named directors receive more negative recommendations from Institutional Shareholder Services, a proxy advisory firm, and significantly more negative votes from shareholders than directors in a benchmark sample. They are also more likely than other independent directors to leave sued firms. Overall, shareholders use litigation along with director elections and director retention to hold some independent directors more accountable than others when firms experience financial fraud.     

Stock performance and the mispricing of accruals

I investigate the relationship between contemporaneous stock-price performance and the persistence of accrued earnings, and its impact on the accrual anomaly. I find that, in a fiscal year, accrued earnings for stocks that have performed poorly are less persistent in predicting future earnings than accrued earnings for stocks that have performed moderately. I further find that a hedge-strategy based on accruals earns greater abnormal returns following bad-news years. The results are consistent with conservative accounting causing accrued earnings to be even less persistent in bad-news years and investors failing to efficiently price this differential in persistence.     

Macro to micro: Country exposures,firm fundamentals and stock returns

We outline a systematic approach to incorporate macroeconomic information into firm level forecasting from the perspective of an equity investor. Using a global sample of 198,315 firm-years over the 1998–2010 time period, we find that combining firm level exposures to countries (via geographic segment data) with forecasts of country level performance, is able to generate superior forecasts for firm fundamentals. This result is particularly evident for purely domestic firms. We further find that this forecasting benefit is associated with future excess stock returns. These relations are stronger after periods of higher dispersion in expected country level performance.     

Belief diversity and price informativeness around earnings announcements

The consequences of price informativeness have been extensively studied in the past. In contrast, this study goes a step backward to explore its determinants by examining whether belief diversity facilitates a complete and timely reflection of earnings news into prices. Using a global dataset, we find a higher abnormal return variance ratio (lower post-earnings announcement drift) in the presence of more diversely-informed beliefs among traders. This inference holds despite several robustness checks. Moreover, the cross-country analysis reveals that the documented impact of belief diversity intensifies in countries with higher market development, greater corporate transparency, and stronger investor protection.     

Strategic Conservative Earnings Management of Technology Firms: Evidence from the IPO Market

In this paper, we investigate the conservative earnings management strategies of technology firms in the IPO market. We hypothesize that technology IPOs, due to their fewer tangible assets, more information asymmetry, and higher uncertainties of future cash flows, tend to have higher litigation risk. At equilibrium, technology firms are more motivated to strategically employ conservative earnings management during the IPO process, to mitigate their higher litigation risk. Using a sample of U.S. IPOs, we find that technology IPOs, on average, involve significantly more conservative earnings management, especially during the bubble periods. Our results also show that the conservative earnings management strategies of technology firms tends to have a greater impact on their underpricing than for non‐tech firms, and thus effectively reduce their risk of being a target in the securities class action lawsuits.