Prompting the Benefit of the Doubt: The Joint Effect of Auditor‐Client Social Bonds and Measurement Uncertainty on Audit Adjustments

We design an incentivized experiment to test whether measurement uncertainty elevates the risk that social bonds between auditors and reporters compromise audit adjustments. Results indicate that, when audit evidence is characterized by some residual uncertainty, the adjustments our auditor‐participants require are sensitive to whether auditors have an opportunity to form a modest but friendly social bond with reporters. In contrast, although auditors do not adjust fully even when misstatements are known with certainty, social bonding has no effect in this scenario. Accordingly, our experiment contributes beyond the main effects of social bonding and measurement uncertainty demonstrated in prior research by showing that these forces interact. A practical implication is that regulators and practitioners should consider both the technical and the social challenges facing audits of complex estimates.     

Disclosure Regulation in the Commercial Banking Industry: Lessons from the National Banking Era

I exploit variation in the adoption of disclosure and supervisory regulation across U.S. states to examine their impact on the development and stability of commercial banks. The empirical results suggest that the adoption of state‐level requirements to report financial statements in local newspapers is associated with greater stability and development of commercial banks. I also examine which political constituencies influence the adoption of disclosure and supervisory regulation. I find that powerful landowners and small private banks are associated with late adoption of these regulations. These findings suggest that incumbent groups oppose disclosure rules because the passage of such rules threatens their private interests.     

Financial Reporting and Credit Ratings: On the Effects of Competition in the Rating Industry and Rating Agencies' Gatekeeper Role

This paper studies firms' financial reporting incentives in the presence of strategic credit rating agencies and how these incentives are affected by the level of competition in the rating industry and by rating agencies' role as gatekeepers to debt markets. We develop a model featuring an entrepreneur who seeks project financing from a perfectly competitive debt market. After publicly disclosing a financial report, the entrepreneur can purchase credit ratings from rating agencies that strategically choose their rating fees and rating inflation. We derive the following core results: (1) More rating industry competition leads to stronger corporate misreporting incentives if ratings are sufficiently precise or if rating agencies assume a gatekeeper role. Under imperfect rating industry competition, (2) agencies' gatekeeper role primarily weakens firms' misreporting incentives, which then influences rating agencies' strategies, and (3) firms' misreporting and rating agencies' rating inflation can be strategic complements when agencies assume a gatekeeper role. (4) Regulatory initiatives aimed at increasing rating industry competition or at weakening rating agencies' gatekeeper role improve investment efficiency as long as corporate misreporting incentives are not significantly strengthened.     

Management by the Numbers: A Formal Approach to Deriving Informational and Distributional Properties of “Unmanaged” Earnings

We explore the theoretical relation between earnings and market returns as well as the properties of earnings frequency distributions under the assumption that managers use unbiased accounting information to sequentially decide on real options their firms have and report generated earnings truthfully, with the market pricing the firm based on those reported earnings. We generate benchmarks against which empirically observed earnings‐returns relations and aggregate earnings distributions can be evaluated. This parsimonious model shows a coherent set of results: reported losses are less persistent than reported gains, decision making diminishes the S‐shaped market response to earnings and earnings relate to returns asymmetrically in the way documented by Basu [1997]. Furthermore, the implied frequency distribution of aggregate earnings is neither symmetric nor necessarily single‐peaked. Instead, it may exhibit a kink at zero and look similar to the plots reported by Burgstahler and Dichev [1997]. However, within our model, none of these phenomena are due to reporting noise, bias, or some undesirable strategic managerial behavior. They are the natural consequences of using past earnings as the basis for value increasing managerial decision making that in turn generates the future earnings on which future decisions will be based.     

Wisdom of Crowds: Cross‐Sectional Variation in the Informativeness of Third‐Party‐Generated Product Information on Twitter

This paper examines whether third‐party‐generated product information on Twitter, once aggregated at the firm level, is predictive of firm‐level sales, and if so, what factors determine the cross‐sectional variation in the predictive power. First, the predictive power of Twitter comments increases with the extent to which they fairly represent the broad customer response to products and brands. The predictive power is greater for firms whose major customers are consumers rather than businesses. Second, the word‐of‐mouth effect of Twitter comments is greater when advertising is limited. Third, a detailed analysis of the identity of the tweet handles provides the additional insights that the predictive power of the volume of Twitter comments is dominated by “the wisdom of crowds,” whereas the predictive power of the valence of Twitter comments is largely attributable to expert comments. Furthermore, Twitter comments not only reflect upcoming sales, but also capture an unexpected component of sales growth.