06 Financial: Determinants and Consequences of Financial Reporting Quality

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    Does the Takeover Market Deter Opportunistic Non-GAAP Reporting?
    ( 2019-08-31) Godsell, David ; Phelps, Luke
    We exploit the Foreign Investment and National Security Act (FINSA) to examine the effect of an important managerial disciplining mechanism, the takeover market, on the quality of non-GAAP reporting. FINSA significantly reduced the likelihood of takeover for a large fraction of the CRSP-Compustat universe. We draw inferences using a difference-in-differences research design by contrasting non-GAAP disclosures by FINSAaffected firms with those of unaffected firms, before and after FINSA. We find that FINSA-affected firms more often exclude recurring expenses, more often exclude expenses incremental to those excluded by analysts, and more often use non-GAAP earnings to convert a GAAP-based miss of an earnings forecast to a beat, after FINSA. This effect accentuates predictably with the extent to which FINSA-affected firms are susceptible to the takeover market in the pre-FINSA period, and with the extent to which non-GAAP earnings determine manager compensation. We conclude by documenting a decline in non-GAAP earnings persistence and the value-relevance of non-GAAP earnings after FINSA. Our evidence demonstrates the role of the takeover market in curbing opportunistic non-GAAP reporting.
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    Winning an Award Could Set You Free: Earnings Management and the Balance of Power between CEOs and CFOs
    ( 2019-08-30) Wu, Qinxi
    This paper investigates how the balance of power between chief executive officers (CEOs) and chief financial officers (CFOs) influences the use of earnings management. I employ nationwide awards that recognize CFO excellence as shocks to awardees’ job-market status and use a regression discontinuity design (RDD) to establish causal effects. I find that, compared to nominees who were close to winning the award, awardee CFOs experience a sharp increase in career opportunities, both outside and inside their own firms. Consistent with the view that shifts in bargaining power between the CEO and CFO can mitigate earnings management, I find that awardee firms have a significantly smaller magnitude of discretionary accruals than nominees in the first two years after the award. In addition, winning the award has a substantially negative effect on positive accruals, while the positive effect on negative accruals is less significant. Moreover, I find no evidence that the rise of CFO power triggers an increase in the use of real earnings management in awardee firms. Overall, my findings suggest that the balance of power between CEOs and CFOs plays an important role in the quality of financial reporting.
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    Information Acquisition Costs and Misreporting: Evidence from the Implementation of EDGAR
    ( 2019-08-29) Liu, Yibin
    I study the causal effect of investors' costs in acquiring corporate filings on misreporting. Lower information acquisition costs potentially deter misreporting through enhanced monitoring. However, the countervailing channel is that managers may misreport more anticipating that more investors use accounting information in valuing stocks. I study this empirical question with plausibly exogenous variations in investors' information acquisition costs using the U.S. firms' staggered transition from paper filings of periodic reports to electronic filings on the EDGAR system from 1993 to 1996. I find that lower information acquisition costs lead to an increase in accrual-based and real earnings management: discretionary accruals go up by 1 to 1.5% of lagged total assets and abnormal production costs go up by 1% of lagged total assets. My results highlight an unintended consequence of EDGAR and also the importance of having a wholistic understanding of managers' incentives.
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    The Economic Consequences of Financial Misreporting: Evidence from Employee Responses
    ( 2019-08-28) Gao, Xinghua ; Jia, Yonghong
    This study investigates the economic consequences of financial misreporting arising from employee responses. Specifically, we examine two employee reactions: (1) withdrawing their human capital and (2) reducing holding of employer stock, in both misreporting period and post-restatement period. We find an increase in employee turnover and a decrease in employee holding of employer stock in the post-restatement period (restatement effect) and some evidence that employees start to react in the period of misreporting (misreporting effect). We also find some evidence that the misreporting effect varies with employee tenure in the misreporting period and the restatement effect varies with the severity of misreporting in the post-restatement period. We further show that our results are not driven by labor demand, increased likelihood of executive turnover, declining stock prices, and internal control weakness disclosures, and are robust to a matched sample estimation. Overall, our study provides evidence of human capital costs of financial misreporting to misreporting firms, shedding new light on the negative consequences of accounting failures.
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    The scope of audit committee oversight and financial reporting reliability: Are audit committees overloaded?
    ( 2019-08-27) Ashraf, Musaib ; Choudhary, Preeti ; Jaggi, Jacob
    Audit committee (AC) responsibilities have been increasing over time, prompting concerns that overloading ACs may impair their effectiveness. Using new measures to capture AC responsibilities based on AC charters, we find that greater AC responsibilities are associated with improved financial statement reliability. Contrary to overload concerns, this association is strongest when ACs have very high levels of responsibilities. Cross-sectional analyses indicate greater AC responsibilities improve financial statement reliability at complex firms, following significant governance lapses, when AC members are capable and experienced, and when ACs also meet often to carry out their oversight duties. Further analysis suggests that our AC responsibility results are driven by duties related to financial reporting while, in stark contrast, allocating responsibilities unrelated to financial reporting to the AC (e.g., risk management) detracts from monitoring effectiveness by decreasing financial statement reliability. The latter is consistent with an overload effect driven by responsibilities that distract the AC from its core financial reporting oversight mandate. Our results inform recent regulatory changes at some exchanges to expand AC oversight.
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    Welcome to the Gray Zone: Shades of Honesty and Financial Misreporting
    ( 2019-08-25) Veenstra, Kevin ; Lapointe-Antunes, Pascale ; Brown, Kareen ; Li, Heather
    We examine the influence of CFO/CEO honesty perceptions on earnings management for the largest publicly traded companies in America, and show that visual cues play a significant role. Specifically, after controlling for incentives (i.e. stock-based compensation, bonuses, leverage) and opportunities (i.e. auditor independence, internal control deficiencies), members of senior management perceived to be less honest engage in higher levels of both accruals management and real earnings management. Interestingly, the beneficial impact of perceived honesty on earnings quality is most pronounced when both the CFO and the CEO are perceived to be honest. Findings are consistent with our conjecture that both the CFO and CEO independently contribute to a firm’s reporting environment.
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    The Impact of Governmental Accounting Standards on Public-Sector Pension Funding
    ( 2019-08-24) Chuk, Elizabeth ; Anantharaman, Divya
    The funding policy for defined benefit pension plans covering government employees represents an important decision for government entities sponsoring those plans. In recent years, a number of state and local governments have experienced extreme funding shortfalls (e.g., New Jersey, Illinois, and Detroit), raising concerns about whether government entities are contributing enough to their pensions. Governmental Accounting Standards Board Statements Number 67/68 (hereafter, “GASB 67/68”) fundamentally alter the financial reporting of pension liabilities, by (i) requiring pension liabilities to be estimated using a potentially lower discount rate (which increases estimated liabilities and any funding deficits), and (ii) mandating recognition of funding deficits (surpluses), which were previously only disclosed in footnotes, as a liability (asset) on governmental balance sheets. Although GASB 67/68 only changes financial reporting requirements and acknowledges specifically that funding decisions are outside its scope, we find, for a sample of 114 large state plans, that governments increase pension contributions upon applying GASB 67/68. The increased funding response is primarily from governments expecting a larger dollar impact upon applying GASB 67/68, and those facing more adverse economic or political consequences from financial statement recognition. Plans that increase funding are also more likely to have passed benefit cuts, suggesting that taxpayers and public employees share the costs. Overall, these responses suggest that governmental entities are willing to take actions with cash flow consequences to avoid recognizing large liabilities on-balance sheet; purely accounting changes, therefore, can have “real” effects on governmental pension policy.
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    Fraudulent Financial Reporting and the Consequences for Employees
    ( 2019-07-17) Choi, Jung Ho ; Gipper, Brandon
    We examine employment effects, such as wages and employee turnover, before, during, and after periods of fraudulent financial reporting. To analyze these effects, we combine U.S. Census data with SEC enforcement actions against firms with serious misreporting (“fraud”). We find, compared to a matched sample, that fraud firms’ employee wages decline by 9% and the separation rate is higher by 12% during and after fraud periods. Employment growth at fraud firms is positive during fraud periods and negative afterward. We explore the heterogeneous effects of fraudulent financial reporting, including thin and thick labor markets, bankruptcy and non-bankruptcy firms, worker movements, pre-fraud wage levels, and period of hire. Negative wage effects are particularly severe in thin labor markets, for bankrupt, fraud firms, and lower wage employees. However, some negative wage effects occur across these sample cuts, indicating that fraudulent financial reporting appears to create meaningful and prevalent consequences for employees. We discuss how our results can be consistent with channels such as labor market disruptions, punishment, and stigma.