Accounting Discretion in Fair Value Estimates: An Examination of SFAS 142 Goodwill Impairments

This study examines Statement of Financial Accounting Standards 142 adoption decisions, focusing on the trade‐off between recording certain current goodwill impairment charges below the line and uncertain future impairment charges included in income from continuing operations. We examine several potentially important economic incentives that firms face when making this accounting choice. We find evidence suggesting that firms' equity market concerns affect their preference for above‐the‐line vs. below‐the‐line accounting treatment, and firms' debt contracting, bonus, turnover, and exchange delisting incentives affect their decisions to accelerate or delay expense recognition. Our study contributes to the accounting choice literature by examining managers' use of discretion when adopting a mandatory accounting change and by developing and testing explicit cross‐sectional hypotheses of the determinants of firms' preferences for immediate below‐the‐line versus delayed above‐the‐line expense recognition.     

R&D capitalization and audit fees: Evidence from China

Our study investigates the association between capitalized R&D costs and audit fees and whether this association reflects the effect of earnings management. By exploring Chinese listed firms, we find that capitalized R&D costs are positively associated with audit fees, where such positive association holds for both the discretionary and nondiscretionary portions of capitalized R&D costs. Moreover, the positive association between the discretionary portion of capitalized R&D costs and audit fees is more pronounced for firms with stronger incentives to manipulate earnings. Overall, our findings imply that firms' reporting incentives affect how auditors react to clients' accounting choices. This in turn suggests that auditors believe some firms capitalize R&D to manipulate earnings, and the resulting earnings-management concerns lead them to charge higher fees.     

Partial cross ownership and tacit collusion

We examine the effects that passive investments in rival firms have on the incentives of firms to engage in tacit collusion. In general, these incentives depend in a complex way on the entire partial cross ownership (PCO) structure in the industry. We establish necessary and sufficient conditions for PCO arrangements to facilitate tacit collusion and also examine how tacit collusion is affected when firms' controllers make direct passive investments in rival firms.     

Audit committee diligence around initial audit engagement

Studies focusing on governance mechanisms argue that auditor monitoring is one of several governance mechanisms that exist in the firm, and these mechanisms supplement each other. Extending this argument, I examine whether firms support auditor monitoring with audit committee monitoring when auditor oversight is deemed to be weak. Prior auditing literature argues that audit quality is affected by auditors' lack of familiarity with their clients' activities. Since lack of auditor–client familiarity exists in the first year of auditor–client tenure, I examine whether firms increase their audit committee monitoring during the year of auditor change. For a sample of firms that changed auditors between 2006 and 2012, the findings show that audit committees meet more frequently in the first year of audit engagement. Further tests show that firms' past reporting behavior play a significant role in the demand for more audit committee meetings and the increase in the audit committee meetings in the initial year of auditor engagement positively affects reporting quality.     

Effects of auditor-provided tax services on book-tax differences and on investors' mispricing of book-tax differences

Over the last decade, the joint provision of audit and non-audit services has been criticized for compromising auditor independence and affecting audit quality. Since 2005, the SEC has enacted rules restricting the types of non-audit services audit firms can provide clients. While most non-audit services are prohibited, a range of tax services are still allowed. Therefore, if compromises can emerge from allowing non-audit services, permitting tax services could be problematic. This study investigates the effect of auditor-provided tax services (ATS) on firms' levels of book-tax differences and on investors' mispricing of book-tax differences. Using a propensity-score matched sample from 2000 to 2013, I find strong evidence that firms acquiring ATS exhibit a low level of temporary book-tax differences, which in turn mitigate investors' levels of firms' mispricing. These results do not support regulators' claim that the provision of ATS compromises auditor independence. Instead, it suggests that purchasing ATS can improve overall accounting quality through knowledge spillover and thus help investors better price the value of firms.     

Business Tax reform and CSR engagement: Evidence from China

This study investigates the impacts of tax incentives on firms' CSR engagement. Using the staggered Business Tax reform in China as exogenous shocks, our difference-in-differences estimation shows that tax incentives facilitate firms' CSR disclosure, and a plausible mechanism is the released financial burden. The result remains valid under a battery of robustness checks and is more pronounced for state-owned firms, firms with tighter political connections, firms with transparent information and firms locate in areas with higher degree of social trust. The study provides clear policy implications by elaborating on the favorable impacts of tax incentives on firms' CSR performance.     

Competition in the Audit Market: Policy Implications

The audit market's unique combination of features—its role in capital market transparency, mandated demand, and concentrated supply—means it receives considerable attention from policy makers. We explore the effects of two market scenarios that have been the focus of policy discussions: mandatory audit firm rotation and further supply concentration due to the exit of a “Big 4” audit firm. To do so, we first estimate publicly traded firms' demand for auditing services, allowing the services provided by each of the Big 4 to be differentiated products. We then use those estimates to calculate how each scenario would affect client firms' consumer surplus. We estimate that, for U.S. publicly trade firms, mandatory audit firm rotation would induce consumer surplus losses of approximately $2.7 billion if rotation were required after 10 years and $4.7–5.0 billion if after only four years. We find similarly that exit by one of the Big 4 would reduce client firms' surplus by $1.4–1.8 billion. These estimates reflect only the value of firms' lost options to hire the exiting audit firm; they do not include likely fee increases resulting from less competition among audit firms. The latter could result in audit fee increases between $0.75–1.3 billion per year for mandatory rotation and $0.47–0.58 billion per year for the disappearance of a Big 4 audit firm. Such losses are substantial; by comparison, total audit fees for public firms were $11 billion in 2010.     

Industry informational interactions and corporate fraud

We examine three information channels through which product market interactions in an industry can affect firms' incentives to misreport financial information to investors. We find that lower product market sensitivity to individual firms' information and greater use of relative performance evaluation encourage the commission of financial fraud. Industry structures that give rise to less collection of information about individual firms decrease the probability of fraud detection and increase the probability of fraud commission. We also examine dynamic effects of fraud. Our results suggest that, in fragmented industries, fraud can amplify cyclical fluctuations in the real economy.     

International Accounting Standards and Accounting Quality

We examine whether application of International Accounting Standards (IAS) is associated with higher accounting quality. The application of IAS reflects combined effects of features of the financial reporting system, including standards, their interpretation, enforcement, and litigation. We find that firms applying IAS from 21 countries generally evidence less earnings management, more timely loss recognition, and more value relevance of accounting amounts than do matched sample firms applying non‐U.S. domestic standards. Differences in accounting quality between the two groups of firms in the period before the IAS firms adopt IAS do not account for the postadoption differences. Firms applying IAS generally evidence an improvement in accounting quality between the pre‐ and postadoption periods. Although we cannot be sure our findings are attributable to the change in the financial reporting system rather than to changes in firms' incentives and the economic environment, we include research design features to mitigate effects of both.     

An accountability framework for financial statement auditors and related research questions

We address the following overarching questions: What kind of accountability framework could regulators use to (a) motivate auditors to improve audit quality, and (b) evaluate how well auditors have carried out their duties? We draw on research in accounting, economics, psychology, and neuroscience to critique the accountabilities, incentives, and learning opportunities embedded in auditors’ extant regulatory environment. We first establish that forward-looking estimates are the basis for most financial statement information and that some of these estimates are highly uncertain, which increases the challenges faced by auditors. We propose an accountability framework with two dimensions: rewards versus penalties and processes versus outcomes. We show that auditors’ current regulatory accountabilities generally are in the form of penalties rather than rewards and primarily depend on audit outcomes rather than attributes of auditors’ judgment processes. We provide evidence from a range of disciplines that questions the suitability of the present system for improving the quality of auditors’ judgments and the quality of evaluations of those judgments made by inspectors. We identify four potential changes for improvement in audit quality based on our framework. Each of these identified changes has an impact on one or both of the two dimensions in our framework. For each of these changes, we outline JDM research questions that could be addressed to inform our overarching questions and to provide empirical evidence to help refine our accountability framework and improve audit quality.     

Audit Firm Attributes and Auditor Litigation Risk

This study examines the association between auditors' litigation risk and audit firm attributes. Using professional liability insurance premiums as a proxy for auditors' litigation risk, we present evidence that the risk is lower in audit firms having: (1) separate non-audit and audit divisions; (2) a higher proportion of partners; and (3) a higher annual growth in number of CPAs employed. Additionally, we find that the risk is higher in audit firms having: (1) operating losses; and (2) high revenue growth. Our results are consistent with the idea that audit firms' financial condition and organizational structure affect their independence/ expertise, and, in turn, their litigation risk. Our results are broadly supportive of the PCAOB's (2015) and US Department of Treasury's (2008) views that investors, audit committees, management, and other regulators could benefit from having access to financial and organizational information about audit firms.     

Strategic IPOs and product market competition

We examine firms' incentives to go public in the presence of product market competition. As a result of their greater ability to diversify idiosyncratic risk in the capital market, public firms' owners tolerate higher profit variability than owners of private firms. Consequently, public firms adopt riskier and more aggressive output market strategies than private firms, which improves the competitive position of the former vis-à-vis the latter. This strategic benefit of being public, and thus, the proportion of public firms in an industry, is shown to be positively related to the degree of competitive interaction among firms in the output market, to demand uncertainty, and to the idiosyncratic portion of this uncertainty. Additional empirical predictions concern the effect of a firm's initial public offering on its market share and on its rivals' valuations. We test the model's predictions and find empirical support for most of them.     

A Dynamic Model of Optimal Creditor Dispersion

Borrowing from multiple creditors exposes firms to rollover risk due to coordination problems among creditors, but it also improves firms' repayment incentives, thereby increasing pledgeability. Based on this trade‐off, I develop a dynamic debt rollover model to analyze the evolution of creditor dispersion. Consistent with empirical evidence, I find that firms optimally increase creditor dispersion after poor performance. In contrast, cross‐sectionally higher‐growth firms can support more dispersed creditors. Frequent debt renegotiation limits firms' ability to increase pledgeability by having more creditors. Finally, holding a cash balance while borrowing from multiple creditors improves firms' repayment incentives uniformly across all future states.     

Asymmetric Information and Dividend Policy

We examine how informational asymmetries affect firms' dividend policies. We find that firms that are more subject to information asymmetry are less likely to pay, initiate, or increase dividends, and disburse smaller amounts. We show that our main results are not driven by our sample and that our results persist after accounting for the changing composition of payout over the sample period, the increasing importance of institutional shareholdings, and catering incentives. We conclude that there is a negative relation between asymmetric information and dividend policy. Our results do not support the signaling theory of dividends.     

State ownership and the structuring of lease arrangements

The existing literature provides extensive evidence that firms intentionally structured lease arrangements to achieve off-balance-sheet accounting treatment prior to ASU 842 (FASB, 2016) and IFRS 16 (IASB, 2016). However, this study finds the opposite for Chinese state-owned enterprises (SOEs): compared to non-SOEs, SOEs in China have a higher tendency to use finance leases rather than operating leases. This result remains significant after we control for the possibility that Chinese capital providers are discriminatively extending credit to SOEs in the form of finance leases. We explain SOEs' preference for finance leases by their executives' empire building incentives. Such incentives are created by the executives' hunger for compensation, promotion and subsidies, which are determined by the government. Consistently, we find that SOEs' engagement in finance leases increases with their incentives to expand the firms' size. And indeed, SOE executives obtain more compensation and subsidies by growing their firms with finance leases. Finally, we find that SOEs with higher borrowing costs structure more finance lease arrangements. Such structuring further increases SOEs' financial leverage and, to some extent, decreases their corporate value. Taken together, these results suggest that the benefit of the ASU 842 (or IFRS 16), which aims to bring leased assets onto the balance sheet, may be impaired in situations where executives have strong incentives to build empires.     

Do Key Audit Matters Affect Operating Activities? Evidence from Inventory Management

We investigate whether and how the disclosure of key audit matters (KAMs) affects firms' real operating decisions by examining the association between inventory-related KAMs and firms' inventory management. Exploiting China's recent audit report reform, our difference-in-difference analysis reveals that after the reform, inventory management efficiency increases more for firms subject to inventory-related KAMs than for other firms and the effect is more pronounced for industries in which inventory is material. Further analyses show that inventory-related KAMs positively affect inventory management by attracting external attention and increasing auditor monitoring, which in turn improves inventory management efficiency and operating performance. Our findings suggest that KAM disclosure changes firms’ managerial behaviours and generates a positive externality on real operations.     

Mutual funds' capital gains lock-in and earnings management

Capital gains taxation creates a lock-in effect, increasing investors' incentives to monitor and decreasing portfolio firms' incentives to cater to short-term investors. We show a negative relation between lock-in and portfolio firms' earnings management, and this relation is stronger for capital gains held by tax-sensitive investors. Further, the relation between lock-in and earnings management is stronger when the capital gains tax rate is higher. We show that locked-in funds vote against management and against audit committee members' reappointment following earnings management. Locked-in funds are less likely to exit a position following disappointing earnings announcements, reducing firms' incentive to manage earnings.     

The influence of judges' attitudes on liability assessments related to failed audits exhibiting significant audit team over-time or significant use of off-shore auditors

This study provides evidence on how audit firms' decisions to use offshore (outsourced) auditors or to assign on-site (local) auditors extensive overtime affect judges' evaluation of auditor legal liability I conduct a behavioral experiment in which actual judges responded to a hypothetical audit lawsuit. The results suggest auditors may be penalized during the litigation process depending on the extent of overtime or off-shoring and judges' attitude toward the public accounting profession. Judges with a positive attitude toward public accounting assessed more liability for an audit firm that used offshore (outsourced) auditors than for the use of extensive overtime for on-site auditors or a control condition. However, judges with a negative attitude toward the auditing profession assessed higher liability for auditors except when on-site auditors bore significant overtime in the final weeks of the audit.     

Firms' Off-Balance Sheet and Hybrid Debt Financing: Evidence from Their Book-Tax Reporting Differences

We match large U.S. corporations' tax returns during 1989–2001 to their financial statements to construct a firm‐level proxy of firms' use of off‐balance sheet and hybrid debt financing. We find that firms with less favorable prior‐period Standard & Poor's (S&P) bond ratings or higher leverage ratios in comparison to their industry report greater amounts of interest expense on their tax returns than to investors and creditors on their financial statements. These between‐firm results are consistent with credit‐constrained firms using more structured financing arrangements. Our within‐firm tests also suggest that firms use more structured financing arrangements when they enter into contractual loan agreements that provide incentives to manage debt ratings. Specifically, we find that after controlling for S&P bond rating and industry‐adjusted leverage, our sample firms report greater amounts of interest expenses for tax than for financial statement purposes when they enter into performance pricing contracts that use senior debt rating covenants to set interest rates. Furthermore, we find that the greatest book‐tax reporting changes occur when firms become closer to violating these debt rating covenants. These latter findings are consistent with firms' contractual debt covenants influencing their use of off‐balance sheet and hybrid debt financing.     

Elections and Discretionary Accruals: Evidence from 2004

We examine the accrual choices of outsourcing firms with links to U.S. congressional candidates during the 2004 elections, when corporate outsourcing was a major campaign issue. We find that politically connected firms with more extensive outsourcing activities have more income‐decreasing discretionary accruals. Further, relative to adjacent periods, the evidence is concentrated in the two calendar quarters immediately preceding the 2004 election, consistent with heightened incentives for firms to manage earnings during the election season. The incentives can be attributed to donor firms' concerns about the potentially negative consequences of scrutiny over outsourcing for themselves and for their affiliated candidates.