12 Financial: Financial reporting quality/Earnings smoothing

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    Heightened Shareholder Interest in Firm Affairs following the Inception of Credit Default Swap Trade
    ( 2018-09-01) Ryou, Ji Woo ; Hong, Hyun A ; Srivastava, Anup
    The literature shows that a lender reduces its monitoring of client activities and decreases the accommodation it offers to a distressed client after the lender receives insurance on its outstanding client debt via a credit default swap (CDS). These changes in lender behavior can exacerbate downside risk but can also create upside potential for the reference firm’s shareholders. We predict that the firm’s shareholders, being the residual claimholders, would then increase their interest in firm affairs, by demanding improved corporate governance and the quality of financial reports. We find an increase in independence of the board of directors and a decline in the dual position of chief executive officer and board chairman following the onset of CDS trading. We also find higher earnings response coefficient and trading volumes around the earnings announcement dates and lower post–earnings announcement drift. Overall, our results suggest that shareholders demand and obtain higher quality of, or pay greater attention to, financial reports in the years following the onset of CDS trading.
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    Policy Uncertainty and Loan Loss Provisions in the Banking Industry
    ( 2018-08-31) Ng, Jeffrey ; Saffar, Walid ; Zhang, Janus
    Policy uncertainty is an increasingly important issue facing many economies. In this paper, we examine how banks accrue for loan losses in response to policy uncertainty (PU) and the implications of these accruals in terms of actual loan losses and future liquidity creation. Consistent with banks recognizing more loan losses in anticipation of PU’s depressive effects, we document a contemporaneous positive association between PU and loan loss accruals. This positive association is more pronounced for banks with a riskier loan portfolio and that have a history of lower loan loss reserves. We also find that banks making more loan loss provisions in times of higher PU have significantly higher future loan charge-offs and lower future liquidity creation. Overall, our paper highlights that PU affects the loan loss accruals of banks and that these accruals reflect rational expectations about PU’s depressive effects on the economy.
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    The Effect of Timely Loan Loss Recognition in the Banking System on Firms’ Debt Structure
    ( 2018-08-30) Li, Xiao ; Ng, Jeffrey ; Saffar, Walid
    In this paper, we examine how the system under which banks record loan losses, specifically, the timeliness of loan loss recognition, affects borrowers’ debt structure. Using data from 55 countries, we find that more timely loan loss recognition reduces firms’ reliance on bank debt relative to public debt. This result reflects an equilibrium in which firms in an economy rely less on bank debt when there are greater lending constraints and more borrower monitoring in a more timely loan loss accounting regime. Consistent with such a regime resulting in tighter loan conditions, we find an even lower use of bank debt in countries with stringent bank supervision and among financially constrained and opaque firms. Overall, our study offers new insight into the real effects of banks’ accounting on firms’ debt structure when firms can choose alternative debt providers.
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    Disappearing Working Capital
    ( 2018-08-29) Na, Hyun Jong
    The latter half of the 20th century is characterized with an unprecedented technological development in the human history. This paper examines whether the development in information technology (IT) has had a real consequence on the working capital management of U.S. listed firms over the past five decades. I find that the annual mean (median) value of cash conversion cycle (CCC) of U.S. firms has sharply declined from 105.3 (96.9) days in the 1970s to 64.2 (53.2) days in the 2010s due to a real improvement in inventory and payment cycle. The decline is systematic across all industry and cohort groups and is not affected by accounting-based earnings management. Moreover, I find that one percent increase in IT spending is associated with a reduction of CCC by 0.17 days. I further point out that this real (vis-à-vis accounting) improvement in IT and working capital management re-shapes the asset structure of average U.S. firms, reduces their net working capital balance from 30.5% of average total assets in the year 1970 to only 4.6% in the year 2017, reduces working capital accruals from 18.8% of earnings in the 1970s to only 5.4% in the 2010s, and changes the relationship between earnings and cash flows over time.
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    CEO Sensation Seeking and Financial Reporting Quality
    ( 2018-08-29) Lobo, Gerald ; Ouyang, Bo ; Wang, Chong ; Zhou, Jian
    This study investigates whether CEOs’ sensation seeking is related to their firms’ financial reporting quality. Consistent with a tendency of sensation seekers to defy ethical rules, we find that firms with sensation-seeking CEOs have lower financial reporting quality and higher likelihood of accounting fraud. More specifically, we find that firms led by sensation-seeking CEOs engage in more accrual-based and real earnings management, have higher information opacity and are more likely to have internal control deficiencies and use less conservative accounting. Firms with sensation-seeking CEOs are also more likely to engage in accounting fraud as indicated by the SEC Accounting and Auditing Enforcement Release (AAER). We further find that good corporate governance does not mitigate the adverse effects of sensation-seeking CEOs on financial reporting quality. Finally, we find a positive association between sensation-seeking CEOs and audit fees. Our results are robust to CEO change, instrument variable method and propensity score matching. In summary, our results suggest that the CEO personality trait of sensation seeking plays an important role in financial reporting quality.
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    Audit Quality and Investment Efficiency with Informed Trading
    ( 2018-08-29) Langberg, Nisan ; Rothenberg, Naomi
    We study how informed, strategic trading affects audit quality and investment efficiency. With the auditor's damage payment due to legal liability based on the decrease in the market price after an audit failure, we show that informed trading provides a hedge to the auditor against legal liability risk, and weakens incentives for audit quality. In turn, the strategic trader produces more information due to higher gains from trade that are made available by lower audit quality. Moreover, the behavior of liquidity traders affects both audit quality and the extent of informed trading, and is not monotonically related. A stricter legal liability regime leads to higher audit quality and less informed trading. However, prices can be used to guide real investments, such as corporate expansions and stricter liability might lead to lower investment efficiency because with less informed trading, market prices are less informative.
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    The Effect of Short-Selling on Information Arrival around Earnings Announcements: Evidence from Regulation SHO
    ( 2018-08-20) Li, Wei
    Short-sellers assist in impounding negative news more quickly into stock prices and improve price informativeness. However, there is a lack of consistent evidence about when and how short-sellers acquire an information advantage – i.e., private vs. public channels, and incorporate such information into their trading activities. To shed light on these questions, I exploit Reg SHO to examine price informativeness before, during and after earnings announcements. I show that relative to control firms, pilot firms have greater (less) price informativeness before (during) earnings announcements, suggesting that short-sellers are informed via the private channel and that the segment of short-sellers that trade on earnings news is populated predominantly by those who acquire private information prior to earnings releases. I also find that the main results are more pronounced for a sub-sample comprised of firms with low corporate transparency, relative to a sub-sample with high corporate transparency.
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    Where is the Line? The Effect of Narrowed Scope of Discontinued Operations on Earnings Quality and Analysts’ Forecasts
    ( 2018-08-16) Kang, Chao ; Lin, Steve ; Yeung, Eric
    In the past decades, the U.S. accounting standards have been trending toward more narrowed scope for the “below-the-line” items. This study examines whether the quality of “above-the-line” (or core) earnings and analysts’ forecasts is affected by the recent major rule change in this regard (i.e., ASU2014-8), which imposes much more stringent criteria for classifying dispositions as below-the-line items (i.e., discontinued operations). Using data surrounding this rule change, we find that the frequency of reported discontinued operations significantly reduces after the change, suggesting underlying dispositions being buried in the core earnings. More importantly, we find that the persistence and response coefficient of core earnings significantly reduce and that analysts’ forecast error and dispersion increase. Thus, the narrowed scope of below-the-line items required by ASU 2014-8 introduces significant noise to core earnings and increases information asymmetry and uncertainty between managers and financial analysts. Our findings should be of interest to accounting regulators, firm managers, analysts, and investors when they interpret both above- and below-the-line items.