Accounting & Information Assurance

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An Alternative Measure to Detect Intentional Earnings Management through Discretionary Accruals
(2005-06-10) Ibrahim, Salma Samir; Kim, Oliver; Accounting and Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This study proposes an alternative measure of discretionary accruals that can be used in testing for intentional earnings management. Prior research has shown the prevalence of measurement error in all models used to estimate discretionary accruals (Healy (1985), DeAngelo (1986), Jones (1991) and modified Jones models (Dechow et al., 1995). The alternative measure proposed relies on the premise that managers use one or more components of accruals (accounts receivable, inventories, accounts payable, other working capital and depreciation) to manipulate bottom-line income in a given direction, consistent with their incentives. In other words, components of discretionary accruals are expected to be positively correlated. If they are not, this is an indication of high measurement error in the models estimating them. The alternative measure is tested in terms of its power (type II error) and specification (type I error) and compared to the traditional discretionary accruals measure. The power of the tests is measured in random samples with added accrual manipulation as well as a sample of firms targeted by the Securities and Exchange Commission for alleged fraud and a sample of firms that violated their debt covenants. The results indicate that the power of this alternative discretionary measure is higher than that of the traditional discretionary accruals measure. The specification (specificity) is tested in random samples chosen from the full sample as well as random samples chosen from extreme income and cash from operations observations and a sample in which discretionary accruals is a noisy measure of the estimated discretionary accruals. The results indicate that the specification of detecting earnings management behavior is improved by using the alternative discretionary accruals measure.
Analysts Unchained—Expanded Information Processing Capacity and Effort Transfer under Technology Adoption
(2020) Feng, Ruyun; Kimbrough, Michael; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
Analysts acquire and disseminate information to assist investors in equity valuation. Despite their expertise in equity valuation, sell-side analysts are economic agents with limited time and cognitive resources. The constraint on an analyst’s information processing capacity is reflected by the previously documented negative association between an analyst’s forecast accuracy for a focal firm and the total number of firms the analyst covers. While prior research focuses on analysts’ attributes and portfolio firm characteristics as factors impinging on analysts’ information processing capacity, I examine whether information technology—an exogenous factor—can alleviate this constraint. Using the recent exogenous shock of XBRL adoption, I find that the widespread adoption of XBRL expands analysts’ information processing capacity. I document two consequences of this expanded capacity. As an analyst’s information processing capacity increases, the analyst either improvs the forecast accuracy for non-adopting firms in the existing portfolio or increases the size of the portfolio. This finding indicates that the adoption of XBRL generates a positive externality from the adopting firms due to the transfer of analyst effort away from those firms. This study provides the first evidence that exogenous factors such as the adoption of new technology can expand analysts’ information processing capacity, thereby allowing analysts to improve the overall quality of existing coverage and allowing more firms to enjoy the benefits of analyst coverage. The paper also provides the new insight that information externalities can exist among firms that are fundamentally unrelated by identifying another channel—the effort channel—as a source of such externalities.
Analysts' Superiority in Processing Public Information: Evidence from Recommendation Revisions
(2006-07-20) Wang, Zheng; Kim, Oliver; Accounting and Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
In this paper, I study analysts' superiority over the market in processing publicly disclosed earnings information by examining a sample of recommendation revisions issued subsequent to annual earnings announcements within a short period of thirty trading days. The main findings of this study are as follows: First, I provide strong evidence that these recommendation revisions convey valuable information to the market for clarifying the long term implications of recently released earnings. These revisions significantly alter the market's belief about the value implications of announced earnings, suggesting that analysts do have superiority over the market in processing pubic information. Also, the extent of this superiority is positively related to analysts' performance in picking stocks and forecasting earnings. Recommendation revisions issued by analysts with superior performance can make the market revise its assessment about the value implications of previous earnings to a much greater extent than those issued by analysts with moderate performance. Moreover, the extent of this superiority increases with the level of information complexity of earnings signals. Analysts' information is even more valuable to the market for reevaluating previous earnings when the earnings information is more difficult to analyze. Lastly, on average, the extent of this superiority declines after Regulation Fair Disclosure, but still remains significant, suggesting that analysts do not solely rely on inside information from the management to interpret public information. Actually, the decline in the extent of superiority is more likely due to a great increase in the number of revisions issued by analysts whose expertise is not in processing public information. Prior studies document that investors also use subsequent earnings announcements to adjust their estimate of the value implications of previous earnings. This study finds initial evidence that when analysts' information and subsequent earnings announcements provide consistent predictions on how previous earnings is misinterpreted, subsequent earnings announcements become less useful to investors for updating their beliefs regarding the implications of previously released earnings. This paper also compares the extent of analysts' superiority in processing publicly released earnings information across industries and find that analysts exhibit a greater degree of superiority for firms in the manufacturing and retail industry.
ARE INDIVIDUAL INVESTORS INFORMED TRADERS? EVIDENCE FROM THEIR MIMICKING BEHAVIOR
(2020) Polat, M. Fikret; Hann, Rebecca; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
Evidence from a large stream of research suggests that individual investors are uninformed noise traders, who push equity prices away from fundamentals. Recent studies, however, find that individual investors are sophisticated—their trades contain information about future stock prices. In this study, I shed light on this debate by examining a potential channel through which individual investors become informed: trading disclosures of other market participants. Specifically, I examine whether individual investors exploit the proprietary trading strategies of institutional investors revealed in 13F filings. Using a large sample of retail trades, I find a significant positive association between the order imbalance of retail investors and the first buys of institutional investors around the 13F disclosure deadline, with the positive association concentrated among transient and growth-style institutions. The results suggest that not only do individual investors engage in mimicking trading, but their mimicking behavior is selective. I further find that retail investors’ order imbalance predicts future stock returns, with this predictive ability more pronounced in the week around the 13F disclosure deadline, which suggests that individual investors benefit from their selective mimicking trading. Lastly, I find that mimicking trading accelerates the price discovery of upcoming earnings news. Overall, this study enhances our understanding of how individual investors use public disclosures to become informed and contributes to the debate on whether individual investors are informed traders as well as work on the role of SEC disclosures in leveling the informational playing field.
Are the voices of customers louder when they are seen? Evidence from CFPB complaints
(2022) Mazur, Laurel Celastine; Hann, Rebecca; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This paper exploits a unique policy change in the banking sector – the first disclosure of the customer complaints submitted to the Consumer Financial Protection Bureau (CFPB) – to examine whether regulatory scrutiny represents one mechanism through which the disclosure of customer complaints can affect bank behavior. I find that banks with a higher complaint volume on the disclosure date increase mortgage approval rates relative to banks with fewer complaints in the same county, and that this effect is strongest in financially underserved communities. I further find that the disclosure effect is larger for banks under more regulatory scrutiny, namely, those operating in states with stronger consumer financial protection enforcement and those with prior consumer affairs violations. Taken together, the results suggest that the public disclosure of customer complaints, especially when accompanied by regulatory pressure, can serve as a mechanism for customers to influence banks’ consumer lending behavior.
BEYOND RISK: VOLUNTARY DISCLOSURE UNDER AMBIGUITY
(2022) Rava, Ariel; Zur, Emanuel; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
In my dissertation, I examine the impact of ambiguity (Knightian uncertainty), alongside that of risk, on firms’ voluntary disclosure decisions. I confirm the well-known result that an increase in risk—uncertainty over outcomes—is associated with an increase in management guidance (earnings and capital expenditure forecasts). Conversely, I find that an increase in ambiguity—uncertainty over the probabilities of outcomes—is associated with less guidance. Furthermore, I show that ambiguity decreases following voluntary disclosures, consistent with managers being aware of and reacting to heightened ambiguity. Finally, I provide novel empirical evidence showing that guidance under ambiguity has adverse capital market consequences. Even though the ways through which risk impacts managers’ disclosure decisions have been extensively studied in the accounting literature, no extant research has examined whether and how ambiguity impacts these decisions. My findings are consistent with the notion that managers’ take into account the ambiguity in the environment, showing that ambiguity has an important and distinct impact on their voluntary disclosure decisions.
CAUSES AND CONSEQUENCES OF SUPPLY CHAIN TRANSPARENCY: EVIDENCE FROM SUPPLIER IDENTITY DISCLOSURE.
(2021) Choi, Jin Kyung; Hann, Rebecca; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This study examines the determinants and consequences of managers’ choices to disclose the identity about their firm’s first-tier suppliers. I find that reputational benefits, informational benefits, and proprietary costs are important determinants in a firm’s voluntary disclosure choices regarding the identity of suppliers. Further analyses reveal that both shareholders and financial intermediaries find supplier identity disclosures useful. I find that shareholder response to supply chain risk events is timelier for firms that disclose supplier identity. Moreover, supplier identity disclosure appears to help analysts improve earnings forecast accuracy. Taken together, my results shed light on the cost-benefit tradeoffs faced by firms in disclosing supplier identity and how capital market participants use the information disclosed.
Controlling shareholders, audit committee effectiveness, and earnings quality: the case of Thailand
(2010) Kiatapiwat, Wilasinee; Kim, Oliver; Cheng, Shijun; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This study examines the associations of controlling shareholders and audit committee effectiveness with earnings quality. A sample of non-financial Thai listed firms is used in the study because Thailand provides a useful setting for the study of ownership concentration. A unique data set on the voting rights of controlling shareholders and audit committee characteristics is used to test the hypotheses of whether controlling shareholders and audit committees with strong governance characteristics affect the quality of earnings. Earnings quality is measured using (1) Basu's (1997) asymmetric timeliness measure of accounting conservatism, and (2) absolute abnormal accruals estimated from the Dechow and Dichev (2002) and the Jones (1991) models and its variations. Audit committee effectiveness is measured using a composite index comprising four audit committee characteristics. The empirical results show that firms with a controlling shareholder, on average, are associated with both lower accounting conservatism (lower earnings quality) and lower absolute abnormal accruals (higher earnings quality) than firms with no controlling shareholder. Further analysis shows that family- and the government-controlled firms and firms whose controlling shareholders have voting rights below 75%, in particular, are associated with lower accounting conservatism and absolute abnormal accruals. Although the results imply both lower and higher earnings quality for firms with a controlling shareholder compared to firms with no controlling shareholder, the lower (higher) absolute abnormal accruals (earnings quality) simply reflects less conservative accounting practice by firms with a controlling shareholder. The results provide no evidence that audit committees with strong governance characteristics are associated with earnings quality.
CREDIT RATING AGENCIES AS GATEKEEPERS FOR NON-GAAP DISCLOSURE IN THE DEBT MARKET
(2024) Yan, Lu; Kimbrough, Michael; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
To aid investors in assessing earnings persistence, managers often voluntarily provide non-GAAP disclosure, which excludes certain items they characterize as non-recurring from GAAP earnings. The quality of non-GAAP disclosures and their impact on the equity market have been well studied. By contrast, there is little evidence on the impact of these disclosures in the debt market. Credit rating agencies (CRAs) serve as gatekeepers in the debt market, playing an important role in evaluating creditworthiness by actively incorporating accounting information from corporate disclosure. Like shareholders, CRAs also seek to isolate the transitory component of GAAP earnings. For example, Moody’s (2006) and Standard & Poor’s (2008), the two largest rating agencies, state that they derive their credit ratings from adjusted accounting figures by excluding non-recurring items that do not reflect long-term credit risks. Thus, in this paper, I explore the possibility that managers’ non-GAAP disclosures are relevant to CRAs. Consistent with CRAs’ emphasis on long-horizon corporate performance, I provide evidence that CRAs exhibit stronger responses to non-GAAP earnings than GAAP earnings. Using mediation analysis, I find that bondholders rely on CRAs to incorporate earnings information, and such reliance is notably greater for non-GAAP earnings than GAAP earnings. While CRAs do not specifically emphasize the direction of exclusions (i.e., gains or losses), they are attentive to identifying high-quality non-GAAP disclosure, as evidenced by the more positive associations observed between their credit ratings and high-quality non-GAAP earnings. I further find that non-GAAP earnings outperform GAAP earnings for non-GAAP reporters in their predictive power for long-term bankruptcy and default risks, validating CRAs’ motivations to incorporate non-GAAP earnings when assigning credit ratings. Finally, managers appear to be aware of CRAs’ utilization of their non-GAAP disclosure and are thus inclined to offer high-quality but conservative non-GAAP metrics to either achieve or maintain higher ratings when approaching rating upgrades or downgrades. My findings collectively suggest that CRAs view non-GAAP metrics as more relevant tools when evaluating borrowers’ long-term performance and default risks, serving as key intermediaries between non-GAAP reporters and bondholders.
Determining the Impact of Multiple Consecutive Years of Financial Reporting Quality Issues on Investment Efficiency
(2012) Wilford, Amanda Lyn; Gordon, Lawrence A; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
Prior research recognizes that there is a positive relation between financial reporting quality and investment efficiency. The primary object of this dissertation is to examine how financial reporting quality in multiple consecutive years impacts investment efficiency. I use material weaknesses in internal control (MW) as a proxy for poor financial reporting quality and I examine the impact of poor financial reporting quality in multiple consecutive years using an OLS regression model. The results indicate there is a progressively negative impact on investment efficiency tied to the number of consecutive years in which firms report MW. Additionally, I examine whether investment specific financial reporting quality issues have a greater impact on investment efficiency than all other types of financial reporting quality issues. My results suggest that investment specific financial reporting quality issues are driving the negative impact on investment efficiency. These results imply that managers can reduce investment inefficiency by focusing their resources on remediating (correcting) financial reporting quality issues (MW) associated with investment. Current internal control research identifies firms as having either strong or weak internal control dependent upon (1) the presence or absence of MW or (2) the number of MW. This research essentially treats each MW as being of equal importance, Thus, as a secondary objective of this dissertation, in Appendix B, I develop a metric for internal control using the Analytic Hierarchy Process (AHP) to provide a weighting scheme for the different types of MW. Based on Audit Analytics (which separates MW into 21 different categories), I engage 18 participants in an AHP exercise to determine which types of MW have the greatest impact on the financial statements. The results indicate that auditors and managers find MW related to Personnel Weaknesses have the greatest impact on the financial statements. AHP results in weights that are then applied to the 21 different categories of MW. These weights are applied to firms based upon the types of MW reported and the sum of the weights is the measure used for the internal control metric. I then perform a simple OLS regression to test the relation between the internal control metric and stock market returns (Appendix C). I find that a positive relation exists between strong internal controls (as measured by the newly constructed metric) and stock market returns.
Do State Taxes Play a Role in Corporate Investment Decisions? Evidence from Interstate Investment
(2018) Kim, Heedong; Hann, Rebecca N; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
Using a novel data set of state-specific investments at the project level and staggered changes in state corporate income taxes, I examine whether corporate income taxes affect firms’ investment location decisions in the U.S. In contrast to recent studies that document an insignificant effect on firm-level investments, I find that changes in state taxes have a significant effect on project-level investments—firms locate their investment projects in states that cut their corporate taxes. This effect is stronger for projects that are less geographically constrained and for projects that create more jobs. Additional analysis shows that state taxes are particularly relevant for firms’ investment location decisions among competing states. Taken together, this study offers new evidence that state corporate income taxes play an important role in firms’ interstate investment location decisions.
Does Climate Change Transparency Affect Capital Flows? Evidence from Mandatory Greenhouse Gas Emissions Disclosure
(2021) Zotova, Viktoriya; Hann, Rebecca; Zur, Emanuel; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
In this study, I exploit a quasi-natural experiment—the introduction of the mandatory Greenhouse Gas Emissions Reporting Program (GHGRP) in the United States—to examine the impact of climate change regulations on corporate investments, in particular, the effect of non-financial carbon disclosures on firms’ capital investment location decisions. Using unique project-level data on inter-state and foreign direct investments (FDI) for a sample of U.S. corporations, I document two sets of findings. Within the U.S., firms reacted by increasing investments in more environmentally-oriented jurisdictions, while decreasing investments in less environmentally-oriented jurisdictions, making the domestic profile of investment greener. Outside of the U.S., in contrast, I find that, against a backdrop of declining global FDI, the reduction of U.S. FDI was significantly smaller in less environmentally-oriented jurisdictions, making the international profile of investment less green. These results are driven by firms with lower environmental reputation. I show that a channel for the Program’s effect on investment location decisions is the presence of capital market pressure, which is in alignment with the goals of the Program to raise awareness among stakeholders. Consistent with investment and disclosure theory, the results suggest that firms with lower environmental reputation respond to investor pressures by geographically shifting investments into more eco-friendly locations at home but not abroad. Overall, the study demonstrates that carbon disclosure policies, such as the GHGRP, can have a significant effect on firms’ real decisions as well as potential international spillovers.
Earnings Uncertainty and Nonprofessional Intermediaries
(2021) Hyman, Cody Alyssa; Seybert, Nick; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
Prior research is mixed on individual investors’ ability to utilize earnings information and generally credits professional information intermediaries with alleviating processing costs. Over the past decade, individual investors increasingly rely on online social networks to help them process the information they use to trade. This paper investigates the role of earnings uncertainty (persistence, predictability, smoothness, and accrual quality) as a processing cost and the ability of nonprofessional intermediaries to ameliorate this cost. Using comments and trades made on a popular social trading platform as raw and applied information, respectively, I show that raw information is impeded by earnings uncertainty while applied information reduces integration costs to improve the use of earnings information.
Financial Reporting: A Look At Different Settings
(2013) Felix, Robert; Cheng, Dr. Shijun; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
The first of two essays examines whether financial reporting is influenced when a firm shares a director with a "central" firm. Central firms are those which are well-connected within the network of firms formed by shared board of directors. Centrality is a driver of influence and since social networks are a channel to spread information, central firms could transmit reporting practices. However, because financial reporting style is presumably firm specific, the central firm's reporting may not be effective for a focal firm. I examine the effect of central firm conservatism and discretionary accruals on the same focal firm attributes. The results show that focal firm conservatism is influenced by that of the central firm after the two firms become interlocked and that influence is concentrated in the first year. However, a firm adopted central firm discretionary accruals over a longer time horizon. The finding was robust to a variety of alternate explanations. Overall, the findings shed light on how financial reporting spreads through a network and adds to our understanding of how influence occurs between two interlocked firms. The second essay examines municipal reporting manipulation. Municipalities use fund accounting to separately track each activity in self-balancing set of accounts. I focus on the general fund, the largest fund, which uses governmental accounting, and the enterprise fund, which accounts for business-like operations and uses corporate-like accounting. Municipalities have a different organizational objective than corporations and could desire to report a small increase in the general fund bottom line to avoid taxpayer's backlash or they could wish to build up their fund balance to for future use. The enterprise fund incentives are also unclear. I find that operating transfers between funds (discretionary accruals) are used in the general (enterprise), but not the enterprise (general), fund to systematically manipulate its bottom line downward. Accordingly, each fund is manipulated downwards using a method that is in line with its accounting system. Further analysis shows that the general fund results are more pronounced in municipalities with heavy citizen involvement. The findings also highlight that institutional factors do not impact both funds in the same manner.
Herd behavior in voluntary disclosure decisions: An examination of capital expenditure forecasts
(2005-06-09) Brown, Nerissa Christine; Gordon, Lawrence A.; Wermers, Russell R.; Accounting and Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This study documents behavior consistent with herding in voluntary disclosure decisions and investigates two possible reasons for this phenomenon. Based on theories of social learning and rational herds, herding in disclosure decisions may be due to managers' use of information reflected in the past disclosure decisions of other firms (informational herding), and/or managers' incentives to maintain or build a good reputation with investors (reputational herding). Employing a duration model for repeated events, I analyze the timing of capital expenditure forecasts for a broad sample of disclosing and nondisclosing firms. Results show that a firm's propensity to release capital expenditure forecasts is positively associated with the proportion of prior disclosing firms within its industry, thus, supporting arguments of herding. This association is significantly higher for less capital-intensive firms and firms operating in highly competitive industries which suggests that incentives to herd are greater for firms facing relatively high competition. To further distinguish between informational and reputational herding, I investigate whether the tendency to herd varies with the content and precision of other firms' forecasts, and with the level of managerial reputation. As predicted, I find that a firm's propensity to disclose increases with the precision of peer firms' forecasts and when peer forecasts signal a decrease in capital expenditures. Also, I find that herding is greater for managers that are comparably less reputable. Overall, the results confirm the existence of herd behavior in capital expenditure forecast decisions and that the behavior is driven partly by informational and reputational incentives. Extensive sensitivity analyses confirm the robustness of these results.
THE HIDDEN FACE OF THE MEDIA: HOW FINANCIAL JOURNALISTS PRODUCE INFORMATION
(2015) Li, Congcong; Hann, Rebecca; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This study investigates how the media produces information. Using a sample of 296,497 Wall Street Journal news articles, I find that news articles written by experienced and reputable financial journalists are more informative about future earnings. I then examine the source of such information advantage by studying the detailed quotes from news articles. I further find that these journalists rely more heavily on first-hand access to management, institutional investors, and other external experts, an important channel through which they produce informative news. Interestingly, however, this information advantage is present only when the experienced and reputable journalists remain independent -- for those journalists that repeatedly cover the same firm or rely primarily on information from management, the networking information advantage is completely muted. Further, I perform two additional tests. In the first test, I employ news articles about firm fundamentals, and in the second I use a revised measure of information content by including Dow Jones Business News. I continue to find that the information advantage of experienced and reputable journalists obtains only when these journalists remain independent. These results suggest that the quality of the media as an information intermediary depends critically on individual journalists' ability to access information from industry networks and provide unbiased news.
Industry Linkages and Audit Firms' Industry Portfolio Choice: Evidence from Product Language
(2016) Wang, Wenfeng; Hann, Rebecca; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
Audit firms are organized along industry lines and industry specialization is a prominent feature of the audit market. Yet, we know little about how audit firms make their industry portfolio decisions, i.e., how audit firms decide which set of industries to specialize in. In this study, I examine how the linkages between industries in the product space affect audit firms’ industry portfolio choice. Using text-based product space measures to capture these industry linkages, I find that both Big 4 and small audit firms tend to specialize in industry-pairs that 1) are close to each other in the product space (i.e., have more similar product language) and 2) have a greater number of “between-industries” in the product space (i.e., have a greater number of industries with product language that is similar to both industries in the pair). Consistent with the basic tradeoff between specialization and coordination, these results suggest that specializing in industries that have more similar product language and more linkages to other industries in the product space allow audit firms greater flexibility to transfer industry-specific expertise across industries as well as greater mobility in the product space, hence enhancing its competitive advantage. Additional analysis using the collapse of Arthur Andersen as an exogenous supply shock in the audit market finds consistent results. Taken together, the findings suggest that industry linkages in the product space play an important role in shaping the audit market structure.
THE INFLUENCE OF PUBLIC EQUITY OWNERSHIP ON EARNINGS MANAGEMENT THROUGH THE MANIPULATION OF OPERATIONAL ACTIVITIES
(2011) Kim, Yura; KIMBROUGH, MICHAEL D; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This paper examines whether public equity firms and private equity firms with public debt exhibit different degrees of real earnings management, defined as the manipulation of operational activities in order to influence reported earnings. Public equity firms face intense capital market scrutiny that their private equity counterparts do not. Therefore, this study's comparison of the two types of firms provides insight on the impact of capital market pressure on real earnings management behaviors. The impact of capital market pressure is not clear ex ante. On the one hand, the scrutiny associated with the public equity markets may play a disciplining role that leads firms to refrain from activities that distort reported earnings. On the other hand, the penalties faced by public equity firms that fail to meet earnings benchmarks may put additional pressure on top managers to report positive and improved earnings and hence, may lead to greater distortion of reported earnings through the manipulation of operational activities. Consistent with the latter possibility, I find that public equity firms are more likely than private equity firms to opportunistically alter normal operations to improve earnings by cutting R&D spending, by pushing sales through discounts and promotions, and by lowering costs of sales through overproduction. I find no difference in abnormal discretionary expenses between public equity and private equity firms. Although private equity firms with public debt do not face the same capital market pressure that public equity firms face, they are not immune from incentives to engage in real earnings management. Specifically, I find that private equity firms with public debt engage in a greater degree of real earnings management as their debt moves closer to default. Given that debt claims become more like equity claims as a firm's debt moves closer to default, this finding suggests that public debtholders exert similar pressure to public equity holders when their claims become more equity-like. Moreover, private equity firms with public debt that do engage in real earnings management appear to emphasize the zero earnings benchmark, consistent with prior research, suggesting that this benchmark is of primary importance to creditors. In addition, I assess the performance implications of capital market-induced real earnings management, by examining its association with one-year ahead industry-adjusted return on assets (ROA). I find that public equity firms that just meet earnings benchmarks while altering real operating activities suffer from lower future industry-adjusted ROA than private equity firms that just meet earnings benchmarks while altering real operating activities. The finding for the public equity firms validates concerns that operating decisions made in response to capital market pressure may negatively impact future firm performance. On the other hand, the results for private equity firms indicate that alterations of operating activities made in the absence of capital market pressure are more likely to be strategically sound.
An Integrated Analysis of the Corporate General Counsel's Impact on Accounting Choices and Legal Risk
(2015) Ham, Charles; Kimbrough, Michael; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
Companies are increasingly relying on highly paid corporate general counsels (GCs) to help manage the risks of costly regulatory sanctions and shareholder lawsuits associated with their firms' accounting and overall business practices. While recent research documents the role of the GC on specific decisions in isolation, whether and how GCs fulfill their intended role of managing their firms' expected legal costs remains an open question. I document several ways in which GCs affect the expected legal costs associated with their firms' accounting choices. The analysis is based on the insight that the expected legal costs associated with the firm's accounting choices depend on three factors: (1) the extent to which the firm undertakes legally risky accounting practices, (2) the likelihood that such practices are detected by outsiders, and (3) the severity of penalties outsiders impose on the firm upon detection. Managers can affect the first factor by taking the external legal environment as given and altering their internal decisions accordingly, whereas managers can affect the latter two factors by altering the firm's external legal environment through their influence on the intensity of outside monitoring and enforcement. I provide evidence that the GC decreases the firm's expected legal costs via all three factors. First, firms with an influential GC (GC firms) display a preference for real earnings management relative to accrual earnings management and GC firms accelerate the recognition of losses in earnings, both of which entail less legal risk. Second, firms that make aggressive accounting choices are less likely to be targeted by SEC enforcement actions in the presence of an influential GC. This finding indicates that GCs are able to advise their firms about how to use accounting discretion in a way that avoids unwanted regulatory scrutiny. Third, GC firms are less likely to be sued following a restatement announcement. When their firms are sued, the lawsuits are more likely to be dismissed and the settlement amounts are lower. These findings indicate that the GC's advocacy is associated with a reduction in the severity of penalties outsiders impose on the firm when improper accounting choices are discovered. The analyses culminate with an examination of the GC's effect on the firm's overall corporate risk and the market's assessment of the GC's contribution to the firm. I find that GC firms are associated with lower corporate risk as measured by the volatility of future stock returns and lower levels of future risky investments in the form of capital expenditures and research and development expenditures. Finally, the market responds favorably in years that firms appoint a GC to the top management team, consistent with the market perceiving the net impact of GCs' activities to be value enhancing.
Internal Control, Enterprise Risk Management, and Firm Performance
(2007-08-02) Tseng, Chih-Yang; Gordon, Lawrence A; Business and Management: Accounting & Information Assurance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)
This dissertation investigates two research questions arising from the regulation of internal controls required by Sarbanes-Oxley Act of 2002 (SOX). The first research question asks whether better internal controls can enhance firm performance? To address this question, the relation between market-value and internal control is estimated by a residual income model. Firms with weak internal controls are identified as those that disclose material weaknesses in internal controls in periodic filings from August 2002 to March 2006, as required by SOX. The empirical results, based on a sample of 708 firm-years with the disclosures of material weaknesses, show that firms with weak internal controls have lower market-value. Building on the' efforts for SOX to improve internal controls, more and more firms are starting to adopt Enterprise Risk Management (ERM), because sound internal control system rests on adequate and comprehensive analysis of enterprise-wide risks. In light of this trend triggered by SOX, the second research question in this dissertation asks whether implementation of ERM has an impact on firm performance? The basic approach to answer this question uses a contingency perspective, since all risks arise from the firm's internal and external environment. More specifically, the basic argument states that the relation between ERM and firm performance is contingent on the proper match between ERM and five key contingency variables: environment uncertainty, industry competition, firm size, firm complexity, and monitoring by the firm's board of directors. A sample of 114 firms disclosing the implementation of ERM in their 2005 10Ks and 10Qs are identified by keyword search in EDGAR database. In developing the proper match, high performing firms are defined as those with greater than 2% one-year excess return to develop the proposed proper match. An ERM index (ERMI) is constructed based on the Committee of Sponsoring Organizations (COSO) ERM's (2004) definition of four objectives: strategy, operation, reporting, and compliance. The contingency view is supported by the empirical evidence, since the deviation from the proposed proper match is found negatively related to firm performance.

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