The emerging growth company status on IPO: Auditor Effort,Valuation, and underpricing

The Securities Act of 1933 governs the going public process and the accompanying registration statement submissions to the Securities and Exchange Commission (SEC). The Jumpstart Our Business Start-ups (JOBS) Act of 2012 created several accommodations under the SEC securities laws for a new group of companies referred to as “emerging growth companies” (EGCs). We examine the associations between auditor effort, initial public offering (IPO) offer prices, and investors’ perceptions of the registrants’ intrinsic value (underpricing) and EGCs’ registration statements utilizing accommodations to reduce financial statement information disclosure. Our finding that auditor effort is reduced suggests that the potential for increased auditor risk for EGCs future financial statements could be higher because of issues related to financial statements not included in the registration statements. We also find a negative (positive) association between EGC filing and IPO offer prices (underpricing). Our results suggest potential unintended consequences associated with EGCs and that auditor effort might not be sufficient to reduce the possibility of future financial statement failures.     

The effect of investor sophistication on the influence of nonfinancial performance indicators on investors’ judgments

This paper presents an experiment that examines how enhanced disclosure of nonfinancial performance indicators affects the stock‐price estimates of nonprofessional and professional investors. Participants were provided with a case study containing excerpts from a hypothetical company’s annual report. The experiment was a 2 (nonprofessional and professional) × 3 (positive nonfinancial performance indicators, negative nonfinancial performance indicators, and financial information only) between‐subjects design. Consistent with conservatism, the nonprofessional investors underreacted in their stock‐price estimates to the positive nonfinancial disclosures, compared with professional investors with task‐specific knowledge. The results from this study suggest that the value of enhanced disclosure of this type may not flow equally to all users of financial reports, if conservatism, and lack of task‐specific knowledge, adversely affect their decision‐making.     

Intangible assets,IFRS and analysts’ earnings forecasts

We investigate whether the adoption of International Financial Reporting Standards (IFRS) in 2005 by Australian firms has been associated with a loss of potentially useful information about intangible assets. We find that the negative association between the accuracy and dispersion of analysts’ earnings forecasts and aggregate reported intangibles previously documented by Matolcsy and Wyatt (2006 ) becomes stronger subsequent to IFRS adoption, primarily for firms with high levels of underlying intangible assets. Our result is largely attributable to reported goodwill, rather than other intangible assets, suggesting that the impairment approach to goodwill valuation required by IFRS conveys more useful information than does the former straight‐line amortization approach. When we investigate a sub‐sample of firms that report lower intangibles under IFRS than under the prior Australian GAAP, we do find some evidence consistent with a loss of useful information relating to intangibles.     

The effect of SFAS 131 on the stock market’s ability to predict industry‐wide and firm‐specific components of future earnings

This study examines the impact of SFAS 131 on the extent to which stock prices incorporate industry‐wide and firm‐specific components of future earnings. By decomposing earnings into industry‐wide and firm‐specific components, this paper finds that the firms that aggregated segments under the old rule experience significant acceleration in the incorporation of future earnings into current stock prices upon adoption of SFAS 131. However, the acceleration of future earnings is mostly driven by the improved incorporation of industry‐wide components of future earnings, which indicates the market’s ability to predict firm‐specific components is not significantly changed. Supplemental analysis suggests that the reduced geographic earnings information is one possible reason for lack of improvement in incorporating firm‐specific earnings into price.     

Adverse effects of uniform written reporting standards on accounting practice,education, and research

When transactions have multiple attributes, achieving uniformity in their classification depends on whether similarities or dissimilarities are of interest; uniformity with respect to both is not possible. The pursuit of uniform written standards at the expense of social norms diminishes the effectiveness of financial reporting in stewardship and governance, and in keeping the security markets informed. A shift to written standards discourages thoughtful classroom discourse on alternatives which develop professional judgment. It also engenders ‘‘by the book” attitudes and drives talent away from accounting programs and, ultimately, from the accounting profession. Judgment and personal responsibility being the hallmarks of a learned profession, the dominance of uniform written standards weakens the claim that accounting programs belong in universities alongside architecture, dentistry, engineering, law, and medicine. Uniformity discourages research and debate in academic and practice forums and promotes increasingly detailed rule-making. It shuts the door on learning through experimentation, making it difficult to discover better ways of financial reporting through practice and comparison of alternatives. Improved financial reporting calls for a careful balance between written standards and unwritten social norms.     

The effects of analyst forecasts and earnings trends on perceptions of management forecast credibility

We examine whether analyst forecasts influence investors’ perceptions of the credibility of a good news management earnings forecast. We hypothesize that the effect of analyst forecasts will depend on whether the analyst forecast confirms management’s forecast and the extent to which management’s forecast is consistent with the prior earnings trend. Findings indicate that the positive effect of a confirming analyst forecast is greater when the management forecast is trend inconsistent than when it is trend consistent. The negative effect of a disconfirming analyst forecast does not differ based on management forecast trend consistency.     

Equity value,implied cost of equity and shareholders’ real options

This study investigates the effects of shareholders’ real options on (i) firm financial performance and (ii) estimations of the implied cost of equity. After measuring the equity value of steady‐state operations using the residual income model, and the abandonment and expansion options using the Black‐Scholes option pricing model, I find that firms with a large expansion (abandonment) option value experience better (worse) financial performance than those with a small such value. I also find that ignoring these options results in a downward bias in implied cost of equity estimates by an average of 1.23 percentage points.     

Evidence on the role of accounting conservatism in monitoring managers’ investment decisions

Watts (2003), among others, argues that conservatism helps in corporate governance by mitigating agency problems associated with managers’ investment decisions. We hypothesize that if conservatism reduces managers’ex ante incentives to take on negative net present value projects and improves the ex post monitoring of investments, firms with more conservative accounting ought to have higher future profitability and lower likelihood (and magnitude) of future special items charges. Consistent with this expectation, we find that firms with more conservative accounting have (i) higher future cash flows and gross margins and (ii) lower likelihood and magnitude of special items charges than firms with less conservative accounting.     

The Moderating Effect of Relative Performance Evaluation on the Risk Incentive Properties of Executives’ Equity Portfolios

We offer evidence that the use of relative performance evaluation (RPE) in CEOs’ incentive contracts influences the effect of risk‐taking incentives on both the magnitude and composition of firm risk. We find that, when the incentive design lacks RPE features, the incentive portfolio vega motivates CEOs to increase total risk through the systematic component because it can be hedged. In contrast, when the incentive design includes RPE features, CEOs prefer idiosyncratic risk because RPE filters out the systematic component of firm performance. We also document that the use of RPE reinforces the incentive portfolio vega's effect on the total risk.     

Accounting quality,information risk and the term structure of implied volatility around earnings announcements

We examine the association between accounting quality, which is used as a proxy for firm information risk, and the behavior of the term structure of implied option volatility around earnings announcements. By employing a large sample of US firms having options traded on their equity during 1996–2010, we find that lower (higher) accounting quality is significantly associated with stronger (weaker) changes in the steepness of the term structure of implied volatility curve around quarterly earnings announcements. This finding (which is robust to controls for business-stemming uncertainty regarding future firm performance) is consistent with a stronger differential of short vs. long-term uncertainty for higher information risk firms, indicating greater uncertainty on the future economic performance of poorer vs. stronger accounting quality firms. We also establish the trading implications of these findings by demonstrating a (profitable in-sample) self-financed option trading strategy that is based on the quality of the accounting information released on earnings announcement days.     

Earnings characteristics and analysts’ differential interpretation of earnings announcements: An empirical analysis

This study provides empirical evidence on factors that drive differential interpretation of earnings announcements. We document that Kandel and Pearson's forecast measures of differential interpretation are decreasing in proxies for earnings quality and pre‐announcement information quality. This evidence yields new and useful insights regarding which earnings announcements are less likely to generate newfound disagreement among analysts and investors. Recent research suggests that investor disagreement can increase investment risk, increase the cost of capital, and cause stock prices to deviate from fundamental value. Therefore, our results support prior intuition that increasing the quality of earnings and pre‐announcement information can improve the efficiency of capital markets.     

The financial performance, capital constraints and information environment of cross-listed firms: Evidence from Mexico

This study provides evidence that Mexican firms that choose to trade in the United States as exchange-listed American Depositary Receipts (ADRs) have significantly weaker ex-post (subsequent to cross-listing) financial performances than Mexican firms that are eligible to list in the United States but choose not to do so. Our study is related to the generalizabililty of two streams of international research: global equity offerings studies (e.g., ( [Errunza & Miller, 2003] and [Foerster & Karolyi, 2000]) [Errunza, V. & Miller, D. 2003 Valuation effects of seasoned global equity offerings. Journal of Banking and Finance (September), 1611-1631; Foerster, S. & Karolyi, G., 2000. The Long-run performance of global equity offerings. Journal of Financial and Quantitative Analysis (December), 499-527]), based on large, multi-country samples, which show that ADR firms substantially underperform local-market benchmark company returns in years following issuance and accounting characteristics of ADR firms research (e.g., (Lang, Raedy, & Yetman, 2003) [Lang, M., Raedy, J. Smith, & Yetman, M. (2003). How representative are firms that are cross-listed in the United States? An analysis of accounting quality. Journal of Accounting Research]), which employ a multi-country sample and conclude that ADR firms are less aggressive in terms of earnings management and that they report accounting data that are more strongly associated with share prices. The cited studies above use relatively large samples, which are usually considered to be advantageous, but such studies tend to mask individual country differences in market efficiency, legal protections for shareholders, disclosure environment, and shareholder-class features that make generalizations tenuous.We show that cross-listed (ADR) Mexican firms, on average, are smaller, more highly levered, and less profitable than non-cross-listed (NCL) firms. Further, logistic regression models for classifying various ADR and NCL groupings of firms, using financial variables and other firm characteristics, are highly significant. While supplemental tests of earnings quality suggest that NCL firms exhibit nominally smoother earnings, that evidence is not sufficient to explain the stronger financial performance reported for those firms relative to ADR firms. Finally, our tests of value relevance, using book value and earnings to explain price, show significantly higher explanatory power for the ADR firms and generally non-significant explanatory power for the NCL firms. The value-relevance results may indicate that investors in Mexican ADR firms benefit from U.S. regulation and that reported market inefficiency in Mexico may result in low demand for financial statements of NCL firms.This study has the advantage of focusing on a single, emerging-market economy (Mexico, the United State's second-largest trade partner) in contrast to most previous ADR research that uses multi-country samples dominated by developed-market countries. It is also one of the first ADR studies to deal with selection-bias issues by comparing ADR and NCL firms. To gain these advantages, however, we must conduct tests on and draw conclusions from a relatively small sample.     

The Real Effects of FAS 166/167 on Banks’ Mortgage Approval and Sale Decisions

We examine the real effects of FAS 166 and FAS 167 on banks’ loan‐level mortgage approval and sale decisions. Effective in 2010, these standards tightened the accounting for securitizations and consolidation of securitization entities, respectively, causing banks to recognize an estimated $811 billion of securitized assets on balance sheet. We find that banks that recognize more securitized assets exhibit larger decreases in mortgage approval rates and larger increases in mortgage sale rates. These effects significantly exceed those of banks’ off–balance sheet securitized assets, consistent with our results being driven by the consolidation of securitization entities rather than by securitization per se. We conduct tests that help rule out the financial crisis as an alternative explanation for our results. Further analyses suggest that mechanisms underlying the results include consolidating banks’ reduced regulatory capital adequacy, increased market discipline, and consequent desire not to recognize high‐risk mortgages on balance sheet.     

The Informational Role of Short Sellers: The Evidence from Short Sellers’ Reports on US‐Listed Chinese Firms

Using US‐listed Chinese firms as the setting, this paper studies a novel channel through which investors can acquire information about firms’ financial reporting quality, that is, the reports published voluntarily by short sellers. I find that short sellers tend to target firms that have financial reporting red flags and that exhibit ‘good’ operating performance and stock valuations. Targeted firms experience an average three‐day cumulative abnormal return (CAR) of ?6.4%, and ?13.6% for initial coverage of the firm, and the CARs are more negative when the reports allege more severe misconduct of the firms. Non‐targeted firms also experience losses in value following short seller reports, especially when they hire the same non‐Big 4 auditors as targeted firms and when their earnings quality is poor. In comparison, analysts fail to perform proper due diligence and are much less effective than short sellers in exposing misreporting risk in Chinese firms.     

Information disclosure,firm growth,and the cost of capital

We study how information disclosure affects the cost of equity capital and investor welfare in a dynamic setting. We show that a firm’s cost of capital decreases (increases) in the precision of public disclosure if the firm’s growth rate is below (above) a certain threshold. The threshold growth rate is higher when the firm’s cash flows are more persistent, or when other firms in the economy are growing at low rates. While current shareholders always prefer maximum public disclosure, future shareholders’ welfare decreases (increases) in the precision of public disclosure if the firm’s growth rate is below (above) the threshold.     

Sources of earnings variability and their effect on earnings forecasts

Previous research shows that analysts’ forecasts of earnings do not fully incorporate information contained in reported earnings variability. This study investigates whether the inefficient forecast is because of a failure to incorporate observable information on two components of earnings variability: variability in operating performance and income smoothing. Our results show that analysts’ forecasts fully incorporate information contained in earnings variability for firms with high income smoothing and for firms with low operating variability. A smaller serial correlation of forecast errors is observed for firms with low operating variability, which suggests that analysts recognize the permanence in earnings for such firms.     

Audit Firm Tenure,Non‐Audit Services,and Internal Assessments of Audit Quality

We use data from internal assessments of audit quality in a Big 4 firm to investigate the impact of audit firm tenure and auditor‐provided non‐audit services (NAS) on audit quality. We find that first‐year audits receive lower assessments of audit quality and that quality improves shortly thereafter and then declines as tenure becomes very long. Partitioning our sample between SEC registrants and private clients, we find that the decline in audit quality in the long tenure range is attributable to audits of private clients. For audits of SEC registrants, the probability of a high quality audit reaches its maximum with very long tenure. We also find that audit fees are discounted for first‐year audits but auditor effort is higher than in subsequent years. We find no association, on average, between total NAS fees and audit quality in the full sample but observe that total NAS fees are positively associated with quality for SEC registrants and negatively associated with quality for privately held clients. Our findings are important for regulatory policies related to audit firm tenure and auditor‐provided NAS.     

The influence of information presentation order and evaluation time horizon on the outcome effect

The outcome effect occurs when an evaluation is influenced by knowledge of the outcome, even when it is unclear that the outcome provides additional information about the evaluatee's performance. This phenomenon has received considerable attention in the accounting and psychology literatures, which rely on cognitive or motivational factors to account for the outcome effect. However, prior research has not considered the impact of information presentation order or the evaluation time horizon. We evaluate prior research in accounting and conclude that information presentation order could have significantly impacted the outcome effect observed in these studies. We then report the results of an experiment that provides evidence that information presentation order plays a significant role in the existence and magnitude of the outcome effect. In addition, we find that the length of the evaluation time horizon is positively related to the magnitude of the outcome effect when conditions favor a recency effect.     

International equity valuation: the relative importance of country and industry factors versus company‐specific financial reporting information

The relative importance of country‐ and industry‐specified factors vis‐à‐vis company‐specific financial statement–based information in explaining equity valuation multiples in an international setting is examined. Both country‐specific effects via previously identified variables and an indicator variable approach are analysed. While company‐specific factors are predominant in explaining cross‐sectional differences in valuation, country and industry factors have sizable incremental explanatory power over them; the latter are not independent, so their relative importance is influenced by how we adjust for this commonality. Using country indicators provides larger incremental explanatory power than using country‐specific factors, suggesting that previously identified factors may be measured with sizeable error or omitted factors are important.