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.     

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.     

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.     

Political relationships,global financing,and corporate transparency: Evidence from Indonesia

This study examines the role of political connections in firms’ financing strategies and their long-run performance. We view political connections as an example for domestic arrangements which can reduce the benefits of global financing. Using data from Indonesia, we find that firms with strong political connections are less likely to have publicly traded foreign securities. As a result, estimates of the performance consequences of foreign financing are severely biased if value-creating domestic arrangements such as political relationships are ignored. Connections not only alter firms’ financing strategies, they also influence long-run performance. Tracking returns across several regimes, we show that firms have difficulty re-establishing connections with a new government when their patron falls from power, leading closely connected firms to underperform under the new regime and subsequently to increase their foreign financing.     

The Valuation Impact of SEC Enforcement Actions on Nontarget Foreign Firms

This study shows that the Securities and Exchange Commission's (SEC) enforcement intensity toward the foreign firms under its jurisdiction has increased dramatically over the past two decades. Because enforcement events signify an increased threat of future enforcement, I examine the stock returns of foreign firms not targeted by the SEC during windows around enforcement actions that target foreign firms. This design captures the net effects of public enforcement and helps to rule out omitted variables as alternative explanations, because other factors would have to align with enforcement events that do not occur in an obvious pattern (and are therefore unlikely to map onto other news). Nontarget firms experience positive stock returns during the event windows, which is consistent with enforcement constraining the risks of expropriation. The cross‐sectional pattern in returns reveals greater returns for firms from weak home legal environments. Finally, consistent with the market adjusting to a new enforcement regime, the magnitude of event returns declines over time. Overall, SEC enforcement is associated with increases in the value of foreign firms, supporting the premise of the legal bonding hypothesis.     

Differences in the information environment prior to seasoned equity offerings under relaxed disclosure regulation

The SEC promulgated the Securities Offering Reform (SOR) in 2005 to ease disclosure restrictions prior to seasoned equity offerings (SEOs). The SEC argued that SOR would improve the information environment, but critics claimed it would allow firms to hype their stock. This paper is the first to examine the information environment at the time of capital formation under SOR. We find more frequent and accurate management earnings forecasts, more 8-K filings, greater absolute market-adjusted returns, and more positive stock returns leading up to the SEO issue date indicating a richer pre-SEO information environment with capital formation benefits after SOR.     

The effects of cross-border cooperation on disclosure enforcement,earnings attributes,and transparency

This study tests for changes in U.S.-listed foreign firms’ financial reporting properties and transparency when their home market regulators enter an arrangement that facilitates enforcement cooperation with the Securities and Exchange Commission. This arrangement—the International Organization of Securities Commissions’ Multilateral Memorandum of Understanding Concerning Consultation and Cooperation and the Exchange of Information (MMoU)—has explicit disclosure-related provisions. I show that the MMoU is associated with improvements across various measures of accounting properties and transparency. Collectively, the findings help resolve enduring questions about why the earnings quality of U.S.-listed foreign firms diverged from that of U.S. firms during pre-MMoU periods.     

The Sarbanes–Oxley act and cross-listed foreign private issuers

I examine the short- and long-term impact of the 2002 Sarbanes–Oxley Act (SOX) on cross-listed foreign private issuers. Both short- and long-term test results suggest that the costs of SOX compliance significantly exceed its benefits and reduce the net benefits of cross-listings.     

Homophily versus monitoring: Do all female board directors drive the gender assignment of audit partners?

By examining the extent to which the proportion of female board directors affects the gender assignment of engagement partners, this paper contributes to the existing literature in several ways. First, we investigate the French mandatory joint audit setting, giving rise to a set of concerns with regard to the auditor pair composition. Second, we consider female directors according to their positions on the board in order to determine which of the homophily and monitoring arguments plays the greater part in the auditor selection process. Third, we address the moderating effect of the gender quota law on the link between female directorship and the choice of audit engagement partners. Using appropriate estimation methods, we find that female board members appointed to key monitoring positions (female independent directors and female audit committee members) choose gender-diverse engagement partners. However, counter to the gender similarity (homophily) argument, we find that female inside directors are negatively associated with the selection of gender-diverse engagement partners. The association between gender-diverse boards and gender-diverse audit partners is found to be more pronounced in the period following the enactment of the gender quota law, thereby providing some practical and policy implications with regard to capitalising on the benefits of gender diversity. Supplementary analyses support the preponderance of the monitoring argument over the homophily argument in the auditor selection process.     

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.     

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.     

How Common Are Intentional GAAP Violations? Estimates from a Dynamic Model

This paper uses data on detected misstatements—earnings restatements—and a dynamic model to estimate the extent of undetected misstatements that violate GAAP. The model features a CEO who can manipulate his firm's stock price by misstating earnings. I find the CEO's expected cost of misleading investors is low. The probability of detection over a five‐year horizon is 13.91%, and the average misstatement, if detected, results in an 8.53% loss in the CEO's retirement wealth. The low expected cost implies a high fraction of CEOs who misstate earnings at least once at 60%, with 2%–22% of CEOs starting to misstate earnings in each year 2003–2010, inflation in stock prices across CEOs who misstate earnings at 2.02%, and inflation in stock prices across all CEOs at 0.77%. Wealthier CEOs manipulate less, and the average misstatement is larger in smaller firms.     

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.     

Whistleblowers and Outcomes of Financial Misrepresentation Enforcement Actions

Whistleblowers are ostensibly a valuable resource to regulators investigating securities violations, but whether there is a link between whistleblower involvement and the outcomes of enforcement actions is unclear. Using a data set of employee whistleblowing allegations obtained from the U.S. government and the universe of enforcement actions for financial misrepresentation, we find that whistleblower involvement is associated with higher monetary penalties for targeted firms and employees and with longer prison sentences for culpable executives. We also find that regulators more quickly begin enforcement proceedings when whistleblowers are involved. Our findings suggest that whistleblowers are a valuable source of information for regulators who investigate and prosecute financial misrepresentation.     

Tunneling as an incentive for earnings management during the IPO process in China

Using a sample of 185 Chinese IPO firms listed on the Shanghai Stock Exchange during the period 1999–2001, we show that related-party (RP) sales of goods and services could be used opportunistically to manage earnings upwards in the pre-IPO period. We also provide evidence that such behavior may be motivated by the prospect of tunneling opportunities in the post-IPO period, i.e., exploiting economic resources from minority shareholders for the benefit of the parent company. We provide evidence of one such opportunistic tunneling tool: non-repayment by Chinese parent companies of net outstanding corporate loans made to them by their newly listed subsidiaries. Furthermore, we provide evidence in support of our assertion of an association between such tunneling behavior in the post-IPO period and earnings management via abnormal RP sales in the pre-IPO period. Finally, we demonstrate the apparent failure of investors in Chinese IPOs to perceive the link between the two phenomena. The results enhance understanding of the motives for and consequences of earnings manipulation during the IPO process. They highlight a potential additional investment risk facing foreign investors in China’s capital markets as well as in Chinese firms cross-listed in non-Chinese stock exchanges, and have policy implications for China and other emerging markets which need to improve the protection of minority shareholders’ rights.     

Effects of Increasing Enforcement on Financial Reporting Quality and Audit Quality

A widely held assumption in policy making and empirical research is that increasing the strength of public enforcement improves financial reporting quality and audit quality. This paper provides a more nuanced view. In a model with a manager who can manage earnings, a strategic auditor, and an enforcement institution, we show that enforcement and auditing are complements in a weak enforcement regime but can be substitutes in a strong regime. Although stronger enforcement always mitigates earnings management, the effects of different instruments of strengthening enforcement are ambiguous. We show that they can improve or impair financial reporting quality and audit quality, depending on production risk, accounting system characteristics, and the scope of auditing relative to enforcement.     

Limits-to-arbitrage, investment frictions, and the asset growth anomaly

We empirically evaluate the predictions of the mispricing hypothesis with limits-to-arbitrage suggested by Shleifer and Vishny (1997) and the q-theory with investment frictions proposed by Li and Zhang (2010) on the negative relation between asset growth and average stock returns. We conduct cross-sectional regressions of returns on asset growth on subsamples split by a given measure of limits-to-arbitrage or investment frictions. We show that: (i) proxies for limits-to-arbitrage and proxies for investment frictions are often highly correlated; (ii) the evidence based on equal-weighted returns shows significant support for both hypotheses, while the evidence from value-weighted returns is weaker; and (iii) in direct comparisons, each hypothesis is supported by a fair and similar amount of evidence.     

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.     

Unintended consequences of the increased asset threshold for FDICIA internal controls: Evidence from U.S. private banks

We examine the unintended consequences of the 2005 increase from $500 million to $1 billion in the asset threshold for the Federal Deposit Insurance Corporation Improvement Act (FDICIA) internal control reporting requirements. We focus on a test sample of banks that increased their total assets from between $100 million and $500 million prior to the change in regulation to between $500 million and $1 billion within two years following the change. These “affected” banks are no longer subject to the internal control requirements but would have been had the regulation not been changed. We hypothesize that these affected banks are likely to make riskier loans, which will increase the likelihood of failure during the crisis period. We find evidence consistent with this hypothesis. Affected banks have higher likelihood of failure during the crisis period than banks from two different control samples. We also find that auditor reputation (i.e., whether the bank is audited by a Big 4 auditor or an industry specialist auditor) has a moderating effect on the likelihood of failure for these affected banks.     

Public and private enforcement of securities laws: Resource-based evidence

Ascertaining which enforcement mechanisms work to protect investors has been both a focus of recent work in academic finance and an issue for policy-making at international development agencies. According to recent academic work, private enforcement of investor protection via both disclosure and private liability rules goes hand in hand with financial market development, but public enforcement fails to correlate with financial development and, hence, is unlikely to facilitate it. Our results confirm the disclosure result but reverse the results on both liability standards and public enforcement. We use securities regulators’ resources to proxy for regulatory intensity of the securities regulator. When we do, financial depth regularly, significantly, and robustly correlates with stronger public enforcement. In horse races between these resource-based measures of public enforcement intensity and the most common measures of private enforcement, public enforcement is overall as important as disclosure in explaining financial market outcomes around the world and more important than private liability rules. Hence, policymakers who reject public enforcement as useful for financial market development are ignoring the best currently available evidence.