Commitment and Cost of Equity Capital: An Examination of Timely Balance Sheet Disclosure in Earnings Announcements

In this paper, I examine the relation between disclosure commitment and cost of equity capital using accelerated earnings announcement disclosures as a measure of commitment. In settings characterized by imperfect market competition, I find that firms which consistently disclose balance sheet detail in relatively timely earnings announcements have lower costs of capital compared to other firms. This result is statistically significant and economically meaningful, and is robust to various alternative measurements for cost of capital, and alternative designs addressing endogeneity and underlying information quality. Overall, this result is important because it highlights additional dimensions of disclosure commitment (consistency and timeliness), while incorporating important features from theoretical models (information quality and market competition). In particular, my results suggest that consistency and timeliness are salient features of firms' disclosure behavior that have predictable and robust relations with capital market outcomes. This result is robust to controlling for underlying information quality; however, consistent with theory, it is conditional on low levels of market competition.     

Inferring Accounting Information from Corporate Financing Choices: An Examination of Security Issuances in the Banking Industry*

This study examines the impact of regulatory capital and several of its determinants (i.e., earnings, loan loss provisions, charge‐offs and growth) on bank managers' financing decisions and investors' interpretations of those decisions. The analysis is related to two streams of research. We add to the corporate finance literature that seeks to explain the market's reaction to security issuances by developing and testing a refined set of predictions of the demand for debt and equity capital using a sample of capital‐regulated firms (banks). We extend the accounting literature that links regulatory capital‐management decisions with bank performance by examining whether investors infer that performance. We find that bank managers' financing choices reflect their private information regarding the levels of regulatory capital, earnings, and charge‐offs in the issuance year. We document a negative market reaction to capital‐increasing issuances and a positive reaction to capital‐decreasing issuances. A cross‐sectional analysis of that market reaction indicates that investors infer managers' expectations of earnings in the issuance year.     

Earnings Non‐Synchronicity and Voluntary Disclosure

Earnings non‐synchronicity reflects the extent to which firm‐specific factors determine a firm's earnings. Prior research suggests that high earnings non‐synchronicity impedes corporate outsiders' ability to process information. This study examines the impact of earnings non‐synchronicity on managers' decisions to provide earnings forecasts. We propose that high earnings non‐synchronicity motivates managers to issue earnings forecasts to reduce information asymmetry between managers and investors and to preempt costly information acquisition by outsiders. Consistently, we find a positive relation between earnings non‐synchronicity and managers' propensity to issue earnings forecasts, particularly long‐horizon forecasts. This positive relation is weaker when earnings are easier to predict based on the firm's earnings history and is stronger when the firm has higher institutional ownership and greater analyst following. We also find that the market's reaction to management forecasts increases with earnings non‐synchronicity. Overall, the evidence suggests that managers voluntarily provide earnings forecasts to alleviate the adverse consequences of earnings non‐synchronicity. These findings provide a more complete picture about the impact of earnings non‐synchronicity on a firm's information environment, and highlight the effect of the nature of information asymmetry on voluntary disclosures.     

Looking good by doing good: CEO attractiveness and corporate philanthropy

We investigate the effect of male corporate managers' physical appearance—classified into unattractive, average-looking, and attractive—on the philanthropic decisions of Chinese listed firms. We find that compared to average-looking managers, those who rated as attractive do not engage more actively in corporate donations. On the contrary, the probability of donating is approximately 5% higher for unattractive managers than for average-looking managers; further, unattractive managers donate 95% more in charitable giving. To explain these findings, we propose a psychological channel through which physical appearance may influence male managers' charitable donations: Because altruistic behaviors may aggrandize individuals, managers conscious of deficits in their own physical attractiveness may engage in prosocial behavior to increase their attractiveness in the eyes of others. We find consistent evidence that the effect of managers' unattractiveness on philanthropic decisions is stronger in firms with weaker corporate governance; further, we find that the positive impact of corporate donation on financial performance observed in firms led by attractive and average-looking managers is substantially weaker in those firms led by unattractive managers.     

Do Shareholders Assess Managers' Use of Accruals to Manage Earnings as a Negative Signal of Trustworthiness Even When Its Outcome Serves Shareholders' Interests?*

We examine how shareholders' trust in managers is affected by (i) the outcome of earnings management (inconsistent vs. consistent with shareholders' interests) and (ii) the method of earnings management (accruals vs. real methods). Using a controlled experiment, we predict and find that trust is impaired when the outcome of earnings management suggests that managers have put their interests above shareholders' interests and/or when the method of earnings management suggests that managers misreported the firm's economic performance. We argue that shareholders assess managers putting their interests above shareholders' interests as a signal of untrustworthiness because it involves a transfer of the firm's resources away from shareholders to managers. We argue that shareholders also assess managers' use of accruals to manage earnings as a signal of untrustworthiness because, in this instance, managers misreport the firm's economic performance. Finally, we show that trust mediates the combined effects of the outcome of earnings management and the method of earnings management on investment decisions. Our study incrementally contributes to the literature by highlighting the adverse implications of managers' use of accruals to manage earnings even when its outcome serves shareholders' interests.     

Abnormal Accruals and Managerial Intent: Evidence from the Timing of Merger Announcements and Completions

We examine acquiring managers' opportunistic reporting behavior around stock‐for‐stock acquisitions. Using the timing of merger announcements and completions to infer managerial intent, we show that acquirers with the most inflated earnings tend to announce mergers on Fridays, and that they manage earnings several quarters before the merger announcement date. Friday announcers exhibit a stronger negative association between pre‐merger announcement abnormal accruals and post‐merger announcement market performance than non‐Friday announcers. This effect is driven mainly by mergers that are completed relatively quickly after they are announced. Overall, the evidence supports the notion that some acquiring managers inflate earnings prior to announcing the mergers, and time the merger announcements to exploit investor inattention.     

Corporate Governance Reform and Executive Incentives: Implications for Investments and Risk Taking

We investigate the mechanism through which the Sarbanes Oxley Act (SOX) was associated with changes in corporate investment strategies. We document that the passage of the governance regulations in SOX was followed by a significant decline in pay‐performance sensitivity (Delta) and incentives to take risk (Vega) in CEOs' compensation contracts. These changes in compensation contracts are related to a decline in investments, including research and development expenditures, capital investments and acquisitions. Moreover, consistent with the rules in SOX directly affecting CEOs' incentives to take risk, we document that the decline in investments exceeds the amount that would be expected from changes in compensation packages alone. Finally, we also find evidence that the changes in investments are related to lower operating performances of firms, suggesting that these changes were costly to investors. Our evidence speaks to the debate on how corporate governance regulation interacts with firms' and managers' incentives, and ultimately affects corporate operating and investment strategies. Our study suggests that one indirect cost of such regulations in SOX is the significant reductions in corporate risk‐taking activities in the post‐SOX period. The changes in investments were in part due to changes in executive compensation contracts and in part related to increased executives' personal costs of engaging in risky activities.     

The Walk‐down to Beatable Analyst Forecasts: The Role of Equity Issuance and Insider Trading Incentives*

It has been alleged that firms and analysts engage in an "earnings‐guidance game" where analysts first issue optimistic earnings forecasts and then "walk down" their estimates to a level that firms can beat at the official earnings announcement. We examine whether the walk‐down to beatable targets is associated with managerial incentives to sell stock after earnings announcements on the firm's behalf (through new equity issuance) or from their personal accounts (through option exercises and stock sales). Consistent with these hypotheses, we find that the walk‐down to beatable targets is most pronounced when firms or insiders are net sellers of stock after an earnings announcement. These findings provide new insights on the impact of capital‐market incentives on communications between managers and analysts.     

JIT Adoption: The Effects of LIFO Reserves and Financial Reporting and Tax Incentives*

Using matched samples of JIT adopters and nonadopters, we examine the association of JIT adoption with firms' financial reporting and tax incentives, earnings‐management histories, and LIFO reserve levels. We find evidence that adoption decisions are influenced by the interaction of firms' LIFO reserves with their income smoothing, debt covenant, and tax incentives. We also find that adoption is less likely for firms historically engaging in high degrees of earnings management, particularly when such firms have no substantial LIFO reserves. Our study extends earlier research demonstrating a relation between inventory valuation method and year‐end inventory transactions, and documents a relation between earnings‐management incentives and a fundamental supply‐chain design choice.     

Deferred Executive Compensation Policies in Chinese State-owned Enterprises

Since the commencement of industrial reform in China, most Chinese state‐owned enterprises have adopted a deferred executive compensation policy to provide incentives for their management teams. However, the effectiveness of such a policy needs to be evaluated. In this paper, we specify a model of deferred executive compensation policy, in which the compensation for executives is contingent on firms' future revenue. The model suggests that under deferred executive compensation policies, managers exhibit an increasing level of effort in every period. Furthermore, the deferred compensation policy encourages managers to make long‐term investments, which might generate revenue even after the termination of managerial contracts.     

The Effect of Changes in Income Shifting on Affiliate Managers' Internal Reporting Decisions*†

This study examines the interplay between tax and internal reporting incentives among affiliates of multinational corporations (MNCs). MNCs face limited information flows that may prevent affiliates' performance metrics to be responsive immediately to changes in the firm's tax planning. Using granular data of affiliates belonging to MNCs from 21 European countries, our study provides new empirical evidence of affiliate internal reporting responses induced by changing tax plans. When high-tax-rate countries tighten income shifting rules, we first document that income shifting is reduced and low-tax-rate affiliates have less income. Second, we predict and document that managers of these low-tax-rate affiliates offset this decrease in profits by managing upwards a key performance metric: affiliate earnings. Our results are consistent with firms not quickly adjusting the affiliate managers' incentives in the face of changing tax planning strategies, and affiliates managing reported earnings to offset the effect of changes in the tax planning of the firm. Cross-sectional analyses provide further evidence consistent with the theory underlying the main tests. The results support the policy of tightening income shifting rules when the objective is to reduce income shifting, and firms' central management would benefit from considering the implications of changing tax plans on the assessment of local managers.     

Union and Debt: Evidence from Chinese Private Firms

Do unions really matter in China? Using a dataset containing more than 110 thousand Chinese private manufacturing firms, this paper is the first attempt to examine how unions' bargaining power affects firms' capital structures. We find that: (1) the firms' debt levels are often positively associated with their unions' bargaining powers; (2) when a firm is in financial distress, the management is more likely to issue more debt to strengthen its bargaining power against the union and increase its residual income; (3) compared with long-term debt, short-term debt is a better option for the management to increase its bargaining power and residual income. Our research indicates that the unions of private Chinese firms are an important policy instrument for the management rather than useless decorations, which provides valuable insights for us to understand the employee–employer relations and firms' capital structures in emerging economies.     

The Relative and Incremental Explanatory Power of Earnings and Alternative (to Earnings) Performance Measures for Returns*

We analyze the ability of earnings and non‐earnings performance metrics to explain the variability in annual stock returns for industries where we identify, ex ante, an allegedly preferred (for valuation purposes) summary performance metric. We identify three industries where earnings before interest, taxes, depreciation, and amortization (EBITDA) and cash from operations (CFO) are preferred, and three industries where specific non‐GAAP performance metrics are preferred. As a benchmark, we also examine the ability of EBITDA and CFO to explain returns for seven industries for which earnings is the preferred metric. Results for the benchmark earnings industries show that earnings dominates EBITDA and CFO in explaining returns. All other results are inconsistent with the view that perceptions of preferred metrics are reflected in actual aggregate investment behaviors.     

The Relation Between Earnings Management and Non‐GAAP Reporting

Managers have a variety of tools at their disposal to influence stakeholder perceptions. Earnings management and the strategic reporting of non‐GAAP earnings are just two of the available menu choices. We explore how real earnings management and accruals management influence the probability that a company will disclose a non‐GAAP adjusted earnings metric in its earnings press release and the likelihood that it will do so aggressively. We first investigate situations where managers already meet analysts’ expectations either based on strong operating performance or after employing real and accruals management. We find that when solid operating performance alone allows firms to meet expectations, managers do not employ earnings management or non‐GAAP reporting. However, when managers meet expectations using real and accruals management, they are significantly less likely to report a non‐GAAP earnings metric. Next, we explore scenarios where companies fall short of expectations. We find that when they just miss expectations after managing GAAP earnings, they are significantly more likely to employ non‐GAAP reporting, suggesting that the timing and relatively costless nature of non‐GAAP reporting allows managers to appear to meet expectations on a non‐GAAP basis when managed GAAP earnings fall short. Moreover, we find that companies are more likely to report non‐GAAP earnings (and to do so aggressively) when (i) they are unable to use real or accruals earnings management, (ii) are constrained by prior‐period accruals management, and (iii) their operating performance is poor. Taken together, our results are consistent with a substitute relation between non‐GAAP reporting and both real and accruals management.     

Blockholder Exit Threats and Financial Reporting Quality

Recent theoretical and empirical studies suggest that blockholders (shareholders with ownership ≥ 5 percent) exert governance through the threat of exit. Blockholders have strong incentives to gather private information and sell their shares when managers are perceived to underperform. To prevent blockholders from selling their shares and the firm from suffering a stock price decline, managers align their actions with the interests of shareholders. As a result of the greater manager‐shareholder alignment, managers' actions are more likely to be in shareholders' best interest, and consequently there is less need for managers to manipulate earnings. Consistent with these predictions from economic theory, we find evidence that as exit threat increases, firms have higher financial reporting quality. Theory also predicts that the impact of blockholders' exit threat on financial reporting quality (FRQ) should increase as the manager's wealth is tied more closely to the stock price, and this is what we find. Our study contributes to the research on the impact of shareholders on FRQ and to an emerging literature on the impact of blockholders in financial markets. Blockholders play an important role in managers' reporting outcomes through their actions as informed investors.     

Foreign Holding Companies and the US Taxation of Foreign Earnings: Evidence from the Tax Increase Prevention and Reconciliation Act of 2005*

I analyze US multinationals' (MNCs) use of foreign holding companies in their organizational structures and the impact of holding companies on internal capital markets. The look-thru rule in the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) reduces the after-tax cost of foreign intercompany financing transactions. I use TIPRA as a natural experimental setting to test whether a shift in US tax policy that reduces the cost of moving foreign capital increased firms' reliance on foreign holding company subsidiaries. I find that MNCs responded to TIPRA by creating more foreign holding companies. Furthermore, consistent with the policy objectives of TIPRA, I document that MNCs that rely on holding companies gained tax efficiencies in their post-TIPRA foreign internal capital markets, reducing domestic taxation on foreign earnings and easing financial constraints. Overall, my results expand our understanding of foreign organizational structure decisions and their internal financing benefits. I contribute to the tax literature by documenting a response to TIPRA that sheds light on the growing complexity of foreign subsidiary ownership structures.     

China's Nonfinancial Corporate Debt Dynamics

Since the global financial crisis broke out in 2008, China's nonfinancial corporate debt has been rising steadily and rapidly, posing serious threat to China's financial stability. China's rising corporate debt is mainly attributable to three factors: worsening capital efficiency, worsening corporate profitability and high funding costs. Based on a dynamic recursive model developed in the paper, we simulate the trajectories of China's corporate debt‐to‐GDP ratio, and find that if China fails to reverse the current trends in capital efficiency, corporate profitability and financing costs, China's nonfinancial corporate debt‐to‐GDP ratio will continue to rise without converging to a limit. Against most economists' intuition, given the current trends of changes in parameters, higher economic growth will not help China to escape the corporate debt trap. On the contrary, it will make China's corporate debt problem even worse. To avert a corporate debt crisis, China needs to speed up the structural reform and change the growth paradigm so as to enhance capital efficiency and firms' profitability, while reducing firms' financing costs.     

Intra‐Industry Information Transfers and the Post‐Earnings Announcement Drift

This study examines the role of intra‐industry information transfers in the analyst forecast‐based post‐earnings announcement drift. I find that subsequent same‐industry‐peer earnings announcements influence a firm's post‐earnings announcement drift if these subsequent announcements confirm the firm's initial earnings surprise and the firm's industry exhibits ex ante positive (common effect) intra‐industry information transfers. The results suggest that underreaction to industry‐specific information contributes to analyst forecast‐based post‐earnings announcement drift.     

When Does Pre‐IPO Financial Reporting Trigger Post‐IPO Legal Consequences?

Prior research suggests that the fear of litigation precludes most managers from manipulating earnings in the initial public offering (IPO) setting. Yet, managers' restraint is perhaps unwarranted: research has not yet linked instances of aggressive pre‐IPO reporting to increased litigation risk. This paper investigates when aggressive IPO reporting triggers legal consequences. Examining 2,037 IPOs, we find that even when ex post evidence indicates the presence of earnings inflation, litigation is more likely to occur when investors have relied on the suspect earnings during the pricing process. Why might investors rely on some firms' abnormal accruals when valuing the IPO and yet discount the abnormal accruals of other firms? Our analyses suggest that IPO investors incorporate abnormal accrual information into IPO prices in situations where accruals are more likely to reflect information and where other sources of information to help investors make pricing decisions are lacking or are less reliable. In these situations, we find that abnormal accruals do positively correlate with future performance, validating investors' use of this information when pricing these offerings. Yet, when ex post performance reveals that these pre‐IPO abnormal accruals were in fact inflated, we find that litigation emerges to allow harmed shareholders to recover losses incurred dating back to the pricing process—importantly, investors are only harmed if they used those abnormal accruals in pricing the IPO. Collectively, our evidence indicates that litigation in response to earnings inflation does indeed surface in the IPO setting—but only when investors need it to settle the score.     

Last‐Chance Earnings Management: Using the Tax Expense to Meet Analysts' Forecasts*

We assert that the tax expense is a powerful context in which to study earnings management, because it is one of the last accounts closed prior to earnings announcements. Although many pre‐tax accruals must be posted in the year‐end general ledger, managers estimate and negotiate tax expense with their auditors immediately prior to earnings announcements. We hypothesize that changes from third‐ to fourth‐quarter effective tax rates (ETRs) are negatively related to whether and how much a firm's earnings absent tax expense management miss analysts' consensus forecast, a proxy for target earnings. We measure earnings absent tax expense management as actual pre‐tax earnings adjusted for the annual ETR reported at the third quarter. We provide robust evidence that firms lower their projected ETRs when they miss the consensus forecast, which is consistent with firms decreasing their tax expense if non‐tax sources of earnings management are insufficient to achieve targets. We also find that firms that exceed earnings targets increase their ETR, but this effect is less significant. By studying the tax expense in total, rather than narrow components of deferred tax expense, our results provide general evidence that reported taxes are used to manage earnings.