The Interrelation between Audit Quality and Managerial Reporting Choices and Its Effects on Financial Reporting Quality

Two distinct lines of research have been dedicated to empirically testing how financial reporting quality (measured as the earnings response coefficient or ERC) is associated with management's choice of reporting bias and with audit quality. However, researchers have yet to consider how ERCs are affected by either the auditor's reaction to changes in the manager's reporting bias or the manager's reaction to changes in audit quality. Our study provides theoretical guidance on these interrelations and how changes in the manager's or the auditor's incentives affect both reporting bias and audit quality. Specifically, when the manager's cost (benefit) of reporting bias increases (decreases), we find that expected bias decreases, inducing the auditor to react by reducing audit quality. Because we also find that the association between expected audit quality and ERCs is always positive, changes in managerial incentives for biased reporting lead to a positive association between ERCs and expected reporting bias. When the cost of auditing decreases or the cost of auditor liability increases, we find that expected audit quality increases, inducing the manager to react by decreasing reporting bias. In this case, changes in the costs of audit quality lead to a negative association between ERCs and expected reporting bias. Finally, we demonstrate the impact of our theoretical findings by focusing on the empirical observations documented in the extant literature on managerial ownership and accounting expertise on the audit committee. In light of our framework, we provide new interpretations of these empirical observations and new predictions for future research

An improved test for earnings management using kernel density estimation

This paper describes improvements on methods developed by Burgstahler and Dichev (1997, Earnings management to avoid earnings decreases and losses, Journal of Accounting and Economics, 24(1), pp. 99–126) and Bollen and Pool (2009, Do hedge fund managers misreport returns? Evidence from the pooled distribution, Journal of Finance, 64(5), pp. 2257–2288) to test for earnings management by identifying discontinuities in distributions of scaled earnings or earnings forecast errors. While existing methods use preselected bandwidths for kernel density estimation and histogram construction, the proposed test procedure addresses the key problem of bandwidth selection by using a bootstrap test to endogenise the selection step. The main advantage offered by the bootstrap procedure over prior methods is that it provides a reference distribution that cannot be globally distinguished from the empirical distribution rather than assuming a correct reference distribution. This procedure limits the researcher's degrees of freedom and offers a simple procedure to find and test a local discontinuity. I apply the bootstrap density estimation to earnings, earnings changes, and earnings forecast errors in US firms over the period 1976–2010. Significance levels found in earlier studies are greatly reduced, often to insignificant values. Discontinuities cannot be detected in analysts’ forecast errors, while such findings of discontinuities in earlier research can be explained by a simple rounding mechanism. Earnings data show a large drop in loss aversion after 2003 that cannot be detected in changes of earnings

Corporate social responsibility: country-level predispositions and the consequences of choosing a level of disclosure

We study the different levels of corporate social responsibility (CSR) disclosures of the largest European firms. We find that firms are more predisposed to disclose more CSR information in countries with: better investor protection, higher levels of democracy, more effective government services, higher quality regulations, more press freedom, and a lower commitment to environmental policies. Our analysis of the association of different levels of CSR disclosure with share prices indicates that a high level of CSR disclosure is associated with higher share prices, whereas a low level of CSR disclosure in sensitive industries is associated with lower share prices (compared to no disclosure). These results are also present when we analyse changes in CSR disclosure, and are robust to the inclusion of an accounting quality measure in our model. The overall effect of the association of higher levels of CSR disclosure with higher share prices is stronger in countries with more democracy, more government effectiveness, better regulatory quality, and more press freedom. Therefore, market participants find CSR disclosures more informative in countries where investors are in a better position to voice their concerns and where there is better regulation and more effective government implementation of regulations.Nova Forumhttp://www.tandfonline.com/loi/rabr202016-10-30hb201

Return Predictability: The Dual Signaling Hypothesis of Stock Splits

This paper aims to differentiate between optimistic splits and overoptimistic/opportunistic splits. Although markets do not distinguish between these two groups at the split announcement time, optimistic (over-optimistic/opportunistic) splits precede positive (negative) long-term buy-and-hold abnormal returns. Using the calendar month portfolio approach, we show that the zero-investment, ex-ante identifiable, and fully implementable trading strategy proposed in this paper can generate economically and statistically significant positive abnormal returns. Our findings indicate that pre-split earnings management and how it relates to managers’ incentives, is an omitted variable in the studies of post-split long-term abnormal returns

Where do firms manage earnings?

Despite decades of research on how, why, and when companies manage earnings, there is a paucity of evidence about the geographic location of earnings management within multinational firms. In this study, we examine where companies manage earnings using a sample of 2,067 U.S. multinational firms from 1994 to 2009. We predict and find that firms with extensive foreign operations in weak rule of law countries have more foreign earnings management than companies with subsidiaries in locations where the rule of law is strong. We also find some evidence that profitable firms with extensive tax haven subsidiaries manage earnings more than other firms and that the earnings management is concentrated in foreign income. Apart from these results, we find that most earnings management takes place in domestic income, not foreign income.Arthur Andersen (Firm) (Arthur Andersen Faculty Fund

The Role of Accounting in the Financial Crisis: Lessons for the Future

The advent of the Great Recession in 2008 was the culmination of a perfect storm of lax regulation, a growing housing bubble, rising popularity of derivatives instruments, and questionable banking practices. In addition to these causes, management incentives as well as certain U.S. accounting standards contributed to the financial crisis. We outline the significant effects of these incentive structures and the role of fair value accounting standards during the crisis, and discuss implications and relevance of these rules to practitioners, standard-setters, and academics

The growth companies puzzle: can growth opportunities measures predict firm growth?

While numerous empirical studies include proxies for growth opportunities in their analyses, there is limited evidence as to the validity of the various growth proxies used. Based on a sample of 1942 firm-years for listed UK companies over the 1990-2004 period, we assess the performance of eight growth opportunities measures. Our results show that while all the growth measures show some ability to predict growth in company sales, total assets, or equity, there are substantial differences between the various models. In particular, Tobin's Q performs poorly while dividend-based measures generally perform best. However, none of the measures has any success in predicting earnings per share growth, even when controlling for mean reversion and other time-series patterns in earnings. We term this the 'growth companies puzzle'. Growth companies do grow, but they do not grow in the key dimension (earnings) theory predicts. Whether the failure of 'growth companies' to deliver superior earnings growth is attributable to increased competition, poor investments, or behavioural biases, it is still a puzzle why growth companies on average fail to deliver superior earnings growth

Media Attention and Event-Based Grouping of Stocks: An Examination of Stocks Hyped by Media Outlets as Benefiting from the Olympics

We examine five summer Olympics and identify stocks that media outlets hype as benefiting from the Olympics (Olympic stocks). There is a seven-year period from the time that a country first learns it has won the Olympic bid to the start of the games (Olympic time period). We predict that the excitement of the Olympics along with the greater media attention impacts the valuation and risk of Olympic stocks. Consistent with this prediction, we show that Olympic stocks earn higher returns than their matched counterparts and comove more strongly with each other over the Olympic time period. Olympic stocks also exhibit increases in trading volume and stock volatility on days when media outlets have stories linking the firm to the Olympic Games. However, we find no evidence that the Olympic Games translate into stronger fundamentals for Olympic firms or stronger fundamental co-movements. These findings suggest that investors are not purchasing the stocks based on an analysis of fundamentals, but are purchasing them based on their Olympic attribute. To confirm that event-based groupings occur in other settings, we show that co-movement increases for stocks classified by the media as “stay-at-home” stocks at the start of the COVID-19 pandemic. This paper was accepted by Eric So, accounting. Supplemental Material: The online appendix is available at [https://doi.org/10.1287/mnsc.2021.02218](https://doi.org/10.1287/mnsc.2021.02218

Earnings Management: The Effect of Ex Ante Earnings Expectations

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