Accounting →
- 26 Jul 2013
- Working Paper Summaries
Accountability of Independent Directors-Evidence from Firms Subject to Securities Litigation
Shareholders have two publicly visible means for holding directors accountable: They can sue directors and they can vote against director re-election. This paper examines accountability of independent directors when firms experience litigation for corporate financial fraud. Analyzing a sample of securities class-action lawsuits from 1996 to 2010, the authors present a fuller picture of the mechanisms that shareholders have to hold directors accountable and which directors they hold accountable. Results overall provide an empirical estimate of the extent of accountability that independent directors bear for corporate problems that lead to securities class-action litigation. These findings are useful for independent directors to assess the extent of risk they face from litigation, shareholder voting, and departure from boards of sued firms. While the percentage of named directors is small compared with the overall population of directors, individual directors can weigh their risk differently. From a policy perspective, the findings provide insight on the role that investors play in holding directors accountable for corporate performance. Key concepts include: About 11 percent of independent directors are named as defendants in securities lawsuits when the company they serve is sued. Audit committee directors-consistent with concerns about litigation exposure of these directors-and directors who sell shares during the class period are more likely to be sued. Shareholders in sued firms also hold independent directors accountable by voting against them, including a greater negative vote for named directors. Directors of sued firms, and especially those who are named, are also significantly more likely to lose their board seats in the sued firm. This effect is more pronounced after 2002 than before, possibly reflecting greater sensitivity towards the role of corporate directors in recent corporate scandals. Lawsuit outcomes vary when independent directors are named in lawsuits. When directors are named, cases are less likely to be dismissed, and they settle faster and for greater amounts. Some evidence points to the strategic naming of independent directors by the plaintiffs to gain bigger settlements. Closed for comment; 0 Comments.
- 11 Jun 2013
- Working Paper Summaries
Measurement Errors of Expected Returns Proxies and the Implied Cost of Capital
In accounting and finance the implied cost of equity capital (ICC)—defined as the internal rate of return that equates the current stock price to discounted expected future dividends—is an increasingly popular class of proxies for the expected rate of equity returns. Though ICCs are intuitively appealing and have the potential to help researchers better understand the cross-sectional variation in expected returns, much remain unknown about the sources of their measurement errors and how to correct for them; thus their use in regression settings should be interpreted with caution. This paper studies the measurement errors properties of GLS, a popular implementation of ICCs developed by Gebhardt, Lee, and Swaminathan (2001). The paper finds that ICCs can have persistent measurement errors that are associated with firms' risk or growth characteristics, and thus produce spurious results in regression settings. It also finds that ICC measurement errors are driven by not only analyst forecast biases but also functional form assumptions, suggesting that correcting for the former alone is unlikely to fully resolve these measurement-error issues. Together, these findings emphasize the importance of complementing ICC regressions with realized returns to establish robust inferences on expected returns. Key concepts include: The common justification for using ICCs for studying expected returns—that ICCs are far less "noisy" than realized returns—is insufficient without a better understanding of the biases embedded in ICC measurement errors. ICC measurement errors can be persistent, can be associated with firms' risk or growth characteristics, and thus confound regression inferences on expected returns. Due to the cross-sectional association between ICC measurement errors and firms' risk or growth characteristics, standard methods for addressing measurement errors, namely portfolio grouping and instrumental variables, may have limited effectiveness. To convincingly establish an association between expected returns and firm characteristics using ICCs, it is necessary for researchers to complement ICC regressions with regressions using realized returns. Closed for comment; 0 Comments.
- 16 Apr 2013
- Working Paper Summaries
The Auditing Oligopoly and Lobbying on Accounting Standards
The US auditing industry has been characterized as an oligopoly, which has successively tightened from eight key players to four over the last 25 years. This tightening is likely to change the incentives of the surviving big auditors, with implications for their role in our market economy. Motivated by the economic and public policy implications of the tightening audit oligopoly, the authors of this paper investigate the changing relation between the big firms and accounting standards. Accounting standards are a key input in the audit process and, through their effects on financial reporting, can impact capital allocation decisions in the economy. Results show that the big auditors are more likely to identify decreased reliability in proposed standards as the auditing oligopoly has tightened: This suggests that big auditors perceive higher litigation and political costs from the increased visibility that accompanies tighter oligopoly. The findings are also consistent with tighter oligopoly decreasing competition among the surviving firms to satisfy client preferences in accounting standards. The findings do not support the concern that tightening oligopoly has rendered the surviving big firms "too big to fail." Key concepts include: This research investigates the impact of the tightening audit oligopoly on "Big Four" auditors' propensity to discuss decreased "reliability" in accounting standards proposed by the Financial Accounting Standards Board (FASB). "Reliability" is a key attribute of accounting. Moreover, reliability is directly relevant to auditors because it entails "verifiability," another key aspect of auditing. As the auditing oligopoly has tightened, big auditors are more prone to eschew the judgment and risks inherent in less reliable accounting standards. Results provide some descriptive evidence on the evolution of "rules" over "principles" in U.S. Generally Accepted Accounting Principles (GAAP). The growth of rules-based accounting standards is significant because it can result in a collectivization of auditing and financial reporting risks in ways that can be sub-optimal for capital allocation. Results do not support the notion that the tightening oligopoly has rendered the surviving big audit firms "too big to fail." Closed for comment; 0 Comments.
- 04 Feb 2013
- Research & Ideas
Are the Big Four Audit Firms Too Big to Fail?
Although the number of audit firms has decreased over the past few decades, concerns that the "Big Four" survivors have become too big to fail may be a stretch. Research by professor Karthik Ramanna and colleagues suggests instead that audit firms are more concerned about taking risks. Closed for comment; 0 Comments.
- 23 Jan 2013
- Working Paper Summaries
Cost of Capital Dynamics Implied by Firm Fundamentals
Despite ample evidence that expected returns are time varying, there has been relatively little empirical research on estimating the dynamics of firm-level expected returns. Capturing the dynamics of firm-level expected returns is important, because it allows for a better understanding of firm risk over time and can inform investors in tailoring their portfolios to match their desired investment horizons. Findings show that cost of capital is time varying and highly persistent. The authors also demonstrate that the model produces empirical proxies of expected returns that can predict future stock returns up to three years into the future and sorts portfolio returns with near monotonicity. Aside from its practical contributions, this paper adds to a budding finance and accounting literature that studies the properties of expected return dynamics. Key concepts include: The model can forecast stock returns up to three years into the future and tracks economic conditions. From a practical standpoint, the approach has several advantages relative to the current methodologies for estimating expected returns. The model is easy to implement, requiring only realized returns, realized BM ratio, and realized ROE. The model also allows for discount rates to be dynamic and produce a full projection of future—time varying—cost of capital estimates. On average, the term structure of cost of capital, like the yield curve for bonds, is upward sloping. However, during times of high economic uncertainty, as in recessions and crisis periods, the term structure flattens and can be downward sloping. Closed for comment; 0 Comments.
- 09 Nov 2012
- Working Paper Summaries
Securities Litigation Risk for Foreign Companies Listed in the US
In the US, securities class action litigation provides investors with a mechanism to hold companies and managers accountable for violations of securities laws. This study examines the incidence of securities class action litigation against foreign companies listed in the US and the mechanism driving the litigation risk. Looking at more than 2,000 securities class action lawsuits between 1996 and 2010, the authors find that significant litigation risk does exist for foreign issuers, but at rates considerably lower than for US companies. The authors also identify potential factors in lower litigation rates: 1) transaction costs and 2) the lower rate of trigger events such as accounting restatements, missing management forecasts, or sharp drops in stock prices that are needed in a lawsuit context to allege intentional and wrong prior disclosures on the part of managers. This suggests that while the effective enforcement of securities laws is constrained by transaction costs, availability of high quality information (that reveals potential misconduct) can contribute to a well-functioning litigation market for foreign firms listed in the US. Key concepts include: Foreign firms listed in US are only half as likely to have a securities class action lawsuit as comparable US firms. This lower rate is economically meaningful. Transaction costs of pursuing litigation against foreign firms play a role. Firms in countries that are farther from the US, have weaker judicial efficiency in the home country or have a weaker track record of prior US. acquisitions are less likely to be targeted by plaintiff investors and attorneys. Once a lawsuit-triggering event like an accounting restatement, missing management guidance, or a sharp stock price decline occurs, there is no difference in the litigation rates between a foreign and comparable US firm Lower litigation risk for foreign firms implies that, relative to US firms, foreign firms will face less frequent pressure to improve disclosure quality and corporate governance or make other corrective actions following a lawsuit. Closed for comment; 0 Comments.
- 08 Nov 2012
- Working Paper Summaries
Admitting Mistakes: Home Country Effect on the Reliability of Restatement Reporting
The authors study restatements by foreign firms listed in the US, compare the extent of restatements by the foreign firms to that of domestic US firms, and examine the role of home country characteristics on the likelihood of the foreign firms restating their financials. When foreign firms list in the US, they become subject to the same accounting rules and regulations as US firms. However, results suggest that foreign firms listed in the US restate significantly less than comparable US firms. This difference is not because the foreign firms have superior accounting quality but because of opportunistic avoidance of issuing a restatement. The difference is driven primarily by firms originating from countries with weaker institutions. Overall, findings imply that restatements are a less accurate measure of the extent of reporting problems in an international setting compared to US domestic firms. Key concepts include: Foreign firms listed in the US are subject to a less rigorous monitoring and enforcement regime than domestic US firms. Weaker institutions in the firm's country of origin lower financial reporting quality of foreign firms accessing US markets, despite a common set of US rules and enforcement that apply to all foreign firms. An accurate reflection of accounting quality through restatement reporting is a necessary information mechanism for the US Securities and Exchange Commission (SEC) and investors to hold managers and auditors accountable. Fewer restatements can lead to a lower level of scrutiny, which is a concern from the point of view of investor protection. Closed for comment; 0 Comments.
- 07 Nov 2012
- Working Paper Summaries
Causes and Consequences of Linguistic Complexity in Non-US Firm Conference Calls
Does the form in which financial information is presented have consequences for the capital markets? The authors examine the level of linguistic complexity of more than 11,000 conference call transcripts from non-US firms between 2002 and 2010. Findings show that the linguistic complexity of calls varies with country-level factors such as language barriers, but also with firm characteristics. Firms with more linguistic complexity in their conference calls show less trading volume and price movement following the information releases. Overall, these results may be useful to foreign firms that wish to communicate with investors globally. Analysts and investors around the world may also find the results helpful since they might be able to push managers to speak in a less complex manner. This study is the first to analyze conference calls in a cross-country setting. Key concepts include: Language barriers are a significant determinant of linguistic complexity in foreign firm's information disclosure. Linguistic complexity in information disclosures can be associated with lower information content, as measured by abnormal stock return volatility and trading volume. The effect is significant when there is greater (i) implicit (as captured by the presence of foreign investors) or (ii) explicit (as captured by how actively analysts ask questions) demand for the information disclosure. Closed for comment; 0 Comments.
- 30 Aug 2012
- Working Paper Summaries
Incentivizing Calculated Risk-Taking: Evidence from an Experiment with Commercial Bank Loan Officers
Recent research presents convincing evidence that incentives rewarding loan origination may cause severe agency problems and increase credit risk, either by inducing lax screening standards or by tempting loan officers to game approval cutoffs even when such cutoffs are based on hard information. Yet to date there has been no evidence on whether performance-based compensation can remedy these problems. In this paper, the authors analyze the underwriting process of small-business loans in an emerging market, using a series of experiments with experienced loan officers from commercial banks. Comparing three commonly implemented classes of incentive schemes, they find a strong and economically significant impact of monetary incentives on screening effort, risk-assessment, and the profitability of originated loans. The experiments in this paper represent the first step of an ambitious agenda to fully understand the loan underwriting process. Key concepts include: High-powered incentives that penalize the origination of non-performing loans while rewarding profitable lending decisions cause loan officers to exert greater screening effort, approve fewer loans, and increase the profits per originated loan. In line with predictions, these effects are weakened when deferred compensation is introduced. More surprisingly, they find that incentives actually have the power to distort loan officers' perceptions of how a loan will perform. More permissive incentive schemes lead loan officers to rate loans as significantly less risky than the same loans evaluated under pay-for-performance. Closed for comment; 0 Comments.
- 11 Jul 2012
- Research & Ideas
Book Excerpt: ’The Future of Boards’
In an excerpt from The Future of Boards, Professor Jay Lorsch discusses why directors are newly questioning their roles. Closed for comment; 0 Comments.
- 11 Jul 2012
- Research & Ideas
The Future of Boards
In The Future of Boards: Meeting the Governance Challenges of the Twenty-First Century, Professor Jay Lorsch brings together experts to examine the state of boards today, what lies ahead, and what needs to change. Open for comment; 0 Comments.
- 09 Mar 2012
- Working Paper Summaries
Causes and Consequences of Firm Disclosures of Anticorruption Efforts
Academic research on corruption has typically focused on its macro causes and consequences. While the country level is certainly important to understand, it is at the firm level where many questions remain unanswered. This study examines 480 of the world's largest companies, using ratings by Transparency International of firms' public disclosures of strategy, policies, and management systems for combatting corruption. Professors Paul Healy and George Serafeim find that firm disclosures are related to enforcement and monitoring costs, such as home country enforcement, US listing, big four auditors, and prior enforcement actions. Disclosures also reflect industry and country corruption risks. Meanwhile the financial implications of fighting disclosure are more nuanced. Key concepts include: While firm-level research on corruption is still at the formative stage, findings suggest that disclosure is more than cheap talk. Firms with high disclosure on their anticorruption efforts are committed to fighting corruption. The policies and enforcement actions reflected in their disclosures help to protect their public reputation and profitability, but at the cost of slower sales growth in high corruption risk markets. Firms with abnormally low disclosure have roughly 15 percent higher sales growth in corrupt country markets than their high disclosure peers. But this higher growth is accompanied by lower profit margins and return on equity. Firms with abnormally high anticorruption ratings have a lower frequency of subsequent allegations of corruption in the media, suggesting that disclosures reflect their commitment to fighting corruption. Future research could examine (among other issues) what factors, other than monitoring/enforcement costs and risk exposures, explain the differences in firms' level of disclosure and commitment to fight corruption. Closed for comment; 0 Comments.
- 06 Dec 2011
- Working Paper Summaries
What Impedes Oil and Gas Companies’ Transparency?
Oil and gas companies face asset expropriations and corruption by foreign governments in many of the countries where they operate. In addition, most of these companies operate in multiple host countries. What determines their disclosure of business activities and hence transparency? Paul Healy, Venkat Kuppuswamy, and George Serafeim examine three forms of disclosure costs that oil and gas managers could potentially consider. Both the US government and the European Union are currently considering laws that would require oil and gas companies to disclose information about operations in host countries. Key concepts include: Competitive risks are an important factor underlying differences in oil and gas firms' disclosure ratings across the host countries in which they operate. Requiring disclosure of payments to foreign governments is unlikely to increase proprietary costs for oil and gas companies. Mandating disclosures about the performance of oil and gas companies in host countries, however, is likely to increase proprietary costs, particularly risk of expropriations and costs related to product market competition. Companies that are coming from more corrupt home countries tend to be less transparent about their payments to host country governments. Closed for comment; 0 Comments.
- 19 Sep 2011
- Research & Ideas
Doomsday Coming for Catastrophic Risk Insurers?
Insurance "reinsurers" underwrite much of the catastrophic risk insurance taken out to protect against huge disasters natural and man-made. Problem is, says Professor Kenneth A. Froot, reinsurers themselves are in danger of failing from a major catastrophic event. Key concepts include: Reinsurers are not distributing risk adequately enough to be able to cover gargantuan losses. Catastrophic reinsurance is more expensive than it needs to be, meaning fewer firms can afford to buy it. Reinsurers should act more like risk-taking investors and less like risk-averse corporations. Open for comment; 0 Comments.
- 19 Aug 2011
- Working Paper Summaries
The Globalization of Corporate Environmental Disclosure: Accountability or Greenwashing?
Between 2005 and 2008, the world saw a dramatic increase in corporate environmental reporting. Yet this transition toward greater transparency and accountability has occurred unevenly across countries and industries. Findings by professors Christopher Marquis and Michael W. Toffel provide the first systematic evidence of how the global environmental movement affects corporations' environmental management practices. Firms' use of symbolic compliance strategies, for instance, is affected by specific corporate characteristics and by institutional context. This study contributes to a larger body of research on the effects of global social movements and environmental reporting. Key concepts include: Marquis and Toffel study more than 4,600 large publicly traded companies headquartered in 46 countries. They first examine the extent to which environmental pressures from governments and civil society influence corporate environmental transparency. Greater environmental disclosure was exhibited by companies headquartered in countries whose governments are better connected to the global environmental movement via international environmental institutions, and whose citizens are more connected to globalization and are afforded greater civil liberties and political rights. They also identify factors associated with greenwashing, where corporations selectively disclose benign environmental impacts to create an impression of transparency and accountability, while masking their true environmental performance. Visible companies' tendency to selectively disclose was tempered when headquartered in countries whose governments were better connected to the global environmental movement, and whose citizens are more connected to global society and are afforded greater civil liberties and political rights. Closed for comment; 0 Comments.
- 18 Aug 2011
- Working Paper Summaries
Non-Audit Services and Financial Reporting Quality: Evidence from 1978-1980
What are the costs and benefits of auditors providing non-audit services? In this paper, the authors investigate whether high non-audit services (NAS) fees relative to audit fees are associated with poor quality financial reporting. Associate Professor Suraj Srinivasan and colleagues look specifically at a sample of S&P 500 firms during the years 1978-80. The authors thus provide an early history analysis of a long-standing regulatory concern that NAS fees create an economic dependence that causes the auditor to acquiesce to the client's wishes in financial reporting, reducing the quality of the audit. This concern led the Sarbanes-Oxley Act to prohibit auditors from providing most consulting services. The authors find that, contrary to regulatory concerns, NAS are associated with better quality financial reporting: lower earnings management and higher earnings informativeness. Conclusions rely on the specific institutional features of the years 1978-80. Key concepts include: Providing NAS does not automatically lead to weaker audit quality. Greater information systems consulting fees are associated with higher quality financial reporting for various proxies of earnings quality. This area of consulting likely improved the audit firms' knowledge base, leading to improved audit quality. Evidence suggests that the market does not fear an increase in economic dependence from the non-disclosure of NAS. Closed for comment; 0 Comments.
- 16 Aug 2011
- Working Paper Summaries
The International Politics of IFRS Harmonization
Contrary to its staid image in popular culture, accounting has reigned at the forefront of globalization over the last decade. As of 2010, about 100 countries, including all of the world's major economies, either have adopted a common set of accounting principles known as International Financial Reporting Standards, have initiated an IFRS harmonization program, or have in place a national strategy to respond to IFRS. In fact, the proliferation of IFRS worldwide is one of the most important developments in corporate governance today. Through a series of case studies on Canada, China, and India, Assistant Professor Karthik Ramanna analyzes key similarities and differences in the international political dynamics that contribute to countries' responses to IFRS. His framework helps explain and predict countries' decisions on IFRS harmonization, as well as the potential structure and impact of IFRS in the future. Key concepts include: How countries respond to IFRS depends on 1) their access to political power at the IFRS's rule-making body, the International Accounting Standards Board (IASB), which is based in London, and 2) their own direct political power at the IASB. While international politics is not the only or even the deciding element in understanding the growth of IFRS, it is very important. The politics of identity is key in a country's IFRS response strategy. While the Chinese government has been successful in making its voice heard at the IASB, the ability of other emerging markets to do so is less clear, as illustrated by Ramanna's case about India. Ramanna describes the development of IFRS over its first decade, particularly the role of the EU member states and their interests in the establishment and subsequent direction of the IASB. Closed for comment; 0 Comments.
- 15 Jul 2011
- Working Paper Summaries
Poultry in Motion: A Study of International Trade Finance Practices
When engaging in international trade, exporters must decide which financing terms to use in their transactions. Should they ask the importers to pay for goods before they are loaded for shipment, ask them to pay after the goods have arrived at their destination, or should they use some form of bank intermediation like a letter of credit? In this paper, Pol Antràs and C. Fritz Foley investigate this question by analyzing detailed data on the activities of a single US-based firm that exports frozen and refrigerated food products, primarily poultry. The data cover roughly $7 billion in sales to more than 140 countries over the 1996-2009 period and contain comprehensive information on the financing terms used in each transaction. Key concepts include: Firms that are likely to have the highest costs of obtaining external capital tend to be the ones that need it most. Importers are more likely to transact on cash in advance terms when they are based in countries with weak institutions, and external capital also tends to be particularly expensive in these countries. Firms in weak institutional environments are able to overcome the constraints of such environments if they can establish a relationship with their trading partners. As a relationship develops between trading partners, concerns about weak institutions seem to subside, and transactions are more likely to occur on terms that allow payment after goods have arrived. The manner in which trade is financed shapes the impact of macroeconomic and financial crises such as the recent one. For instance, the data show that importers who were transacting on cash in advance terms before the recent crisis reduced their purchases the most. Closed for comment; 0 Comments.
- 25 May 2011
- Working Paper Summaries
Accounting for Crises
A key endeavor of modern economic theory is to understand the causes of panics. This paper shows empirically that currency investors are more likely to get spooked unnecessarily when they have too much information. This finding accords well with global games models, which argue that self-fulfilling panics—i.e., panics unrelated to fundamentals—are more likely to occur when the quality of public information available to investors is very high. Research was conducted by Venky Nagar (University of Michigan) and Gwen Yu (Harvard). Key concepts include: Because crises in high accounting precision countries are more likely to have no fundamental cause, accounting fundamentals are more likely to predict crises when accounting information has low precision. Closed for comment; 0 Comments.
Companies Choreograph Earnings Calls to Hide Bad News
Data from thousands of Wall Street earnings conference calls suggests that many companies hide bad performance news by calling only on positive analysts, according to new research by Lauren Cohen and Christopher Malloy. Closed for comment; 0 Comments.