The International Journal of Accounting

Synopsis

The research problem

This study examines whether the effect of litigation risk on audit quality changes when auditors face high versus low regulatory risk under the Public Company Accounting Oversight Board (PCAOB) inspection regime.

Motivation

The establishment of the PCAOB under the Sarbanes–Oxley Act marked a fundamental change in the regulatory environment for the auditors. At the core of the PCAOB’s oversight of the audits of public companies are the inspections of individual audit engagements. While prior studies have found a positive effect of the PCAOB inspection program on audit quality, little is known about whether and how the regulatory risk imposed by PCAOB inspections influences the effect of litigation risk on audit quality. To the extent that both regulatory oversight and litigation threat share the common objective of motivating auditors to exert sufficient effort and perform high-quality audits, we are motivated to examine whether and how the stringent regulatory environment under the PCAOB regime affects auditors’ perception of, and response to, litigation risk.

Hypothesis

We posit that the significant and constant regulatory threat imposed by PCAOB inspections may change auditors’ perception of litigation, which is more remote and less frequent relative to regulatory inspections, such that litigation risk has a smaller effect on audit quality/effort when auditors face high versus low regulatory risk arising from the PCAOB inspections. However, there also exists opposing arguments that would suggest a nondecreasing effect of litigation risk on audit quality in the presence of high regulatory risk. Thus, we present our hypothesis in the null form: the effects of litigation risk on audit quality are not associated with regulatory risk under the PCAOB inspection regime.

Target population

Researchers, audit practitioners, regulatory authorities, policymakers, and firms.

Adopted methodology

We employ multivariate regression analysis featuring the ordinary least squares (OLS) estimation to test our hypothesis. In additional tests, we also use the probit estimation for binary dependent variables.

Analyses

Using a sample of 34,559 client-firm year observations for the period between 2005 and 2019, we estimate a multivariate regression model to examine whether and how the audit deficiencies identified in the PCAOB inspections influence the effect of litigation risk on audit quality exhibited at the client level.

Findings

Our main findings show that, while regulatory risk (proxied by PCAOB-identified audit deficiencies) and litigation risk (proxied by lawsuits filed against auditors/firms) each has a positive effect on audit quality, the interaction term of the two is negatively associated with audit quality. This rejects our null hypothesis and indicates that litigation risk has a smaller motivational effect when the auditors are faced with greater regulatory risk. Similar results are obtained using audit fees, financial restatements, and the propensity to report small profits as the alternative measures of audit quality. We further validate those results with alternative measures of regulatory risk and litigation risk. Our empirical evidence corroborates the views of audit practitioners, surveyed in Westermann et al. (2019), that auditors are increasingly concerned about regulatory risk, as opposed to litigation risk, under the PCAOB regime.

Synopsis

The research problem

We investigated three questions: (1) Has the usefulness of accounting information in predicting future earnings and cash flows out-of-sample (OOS) changed after the mandatory IFRS adoption? (2) If there is a change in this type of usefulness, is it universal or conditional on institutional characteristics of the adopting countries, such as legal enforcement, securities regulation, and the differences between their domestic accounting standards (DAS) and IFRS? (3) If there is a change in this type of usefulness, does it have an economic significance in terms of improved investment performance?

Motivation or theoretical reasoning

The IASB indicates in its conceptual framework that the objective of financial reporting is to provide information to help existing and potential stakeholders assess the amount, timing, and uncertainty of future net cash inflows to an entity. Therefore, examining whether IFRS achieve this objective using the OOS prediction tests needed in investment practice is critical in evaluating the benefit of the switch from DAS to IFRS. Equally important is to shed light on the debate, in an IFRS setting, about the usefulness of earnings and accruals relative to cash flows in future cash flow prediction.

The test hypotheses

With respect to our first research question, we expected that mandatory IFRS adoption improves national accruals-based accounting systems and strengthens the reporting of cash flows. With respect to our second research question, we expected the level of improvement in the predictive ability of accounting information to vary with national institutions such as legal enforcement, securities regulation, and differences between DAS and IFRS. With respect to our third research question, we expected the enhanced predictive ability of accounting information to translate into improved economic significance of forecasts under IFRS.

Target population

We employed a sample of 1,197 firms from 12 European Union (EU) countries, Australia, and South Africa that mandatorily adopted IFRS in 2005.

Adopted methodology

We developed OOS earnings and cash flow forecasts and tested the statistical significance of the changes in OOS prediction performance using a bootstrapping approach. We also evaluated whether the change in the predictive ability of accounting information following IFRS adoption translated into improved economic significance in terms of portfolio investment performance based on the OOS forecasts.

Analyses

Our analyses focused on comparisons of OOS prediction performance between the pre- and post-IFRS periods, while controlling for economy-wide conditions unrelated to IFRS adoption by constructing a constant matched benchmark sample using non-IFRS firms that have only used DAS. In addition, we analyzed the effect of IFRS adoption on OOS prediction performance conditional on national institutions in both univariate tests and multivariate regression analyses. Finally, we performed portfolio analyses based on the OOS forecasts to evaluate the economic significance of the effect of IFRS adoption.

Findings

We found that the earnings and cash flow forecast accuracy improved after adoption, and the effect persisted after controlling for firm characteristics and institutional characteristics. Total accruals generally remained (became) useful in the prediction of earnings (cash flows) after adoption regardless of national institutions. Earnings did (did not) better inform about future cash flows than cash flows alone under weak (strong) enforcement/regulation and high (low) DAS differences from IFRS. Stock portfolios based on the OOS forecasts generated higher hedge returns after adoption, with exceptions in low-legal-enforcement countries, corroborating the improved forecast accuracy. Overall, our findings suggest that mandatory IFRS adoption comes with an improved accruals-based accounting system and reporting of cash flows.

Synopsis

The research problem

This study examines the impact of chief executive officers (CEOs)’ early-life disaster experiences on corporate tax-avoidance behaviors and explores the mechanisms through which these experiences influence these behaviors. We use the Great Chinese Famine of 1959–1961 (hereafter the Great Famine) as an indicator of early-life disaster experience.

Motivation or theoretical reasoning

Our study is motivated by the following reasons. First, like many major economies worldwide, corporate income tax is an important source of tax revenue in China. The financial impact of corporate income tax on a country’s economy is enormous. Second, the Great Famine was one of the most destructive natural disasters in human history, which is likely to have a lifelong influence on CEOs who lived through the disaster as children and teenagers. Third, corporate tax strategy is a significant accounting, financing, and managerial behavior of firms that is influenced by multiple internal and external factors. However, there are limited findings on the impact of CEOs’ early-life disaster experience on corporate tax decisions. The consequences of this impact remain unclear.

The test hypotheses

We hypothesize that CEOs’ early-life famine experience mitigates corporate tax aggressiveness. We also consider the alternative hypothesis that CEOs’ early-life famine experience increases corporate tax aggressiveness.

Target population

Our sample includes Chinese listed firms from 2013 to 2020 led by CEOs who have or who do not have early-life disaster experiences.

Adopted methodology

We employed ordinary least square regressions in our analyses.

Analyses

Since the Great Famine occurred between 1959 and 1961, we considered CEOs to have experienced famine if they were born prior to or in the year 1961, in a province affected by the Great Famine (e.g., , ; , ). We identified a province as significantly affected by famine if its abnormal death rate was greater than the median abnormal death ratio of all Chinese provinces during the period of famine. Following (), (), (), and (), we used effective tax rate as the first proxy of tax avoidance for a firm. Additionally, in line with () and (), we used the discretionary book-tax differences of firms as an alternative proxy to measure corporate tax avoidance.

Findings

The findings indicate that CEOs who experienced the Great Famine at a young age significantly reduced their firms’ tax-avoidance efforts. Furthermore, the negative association between CEOs’ early-life famine experiences and corporate tax-avoidance behaviors is more pronounced for companies with higher independent director ratios. These negative associations appear more obvious for firms with CEOs who experienced famine early in life and for females. The economic mechanism of the findings demonstrate that CEOs’ famine experiences make them more conservative in investing in innovative projects; they are more likely to fulfill corporate social responsibility and work in state-owned enterprises. Furthermore, firms with lower innovation expenditure, effective corporate social performance, and government ownership are less likely to display tax-avoidance behaviors.

Synopsis

The research problem

This paper investigated the impact of principle-based accounting standards on analyst forecasts.

Motivation

The theoretical and practical debates over whether accounting standards should be more principle-based or rule-based have persisted to this day. Existing research primarily focused on the impact of principle-based standards on managers, auditors, and investors in developed economies. However, whether principle-based standards have played the anticipated positive role in emerging markets with relatively weaker institutional environments—and particularly, how they affect another important participant in financial markets, namely, analysts—is the research gap we wished to further explore.

The test hypotheses

We tested the following hypotheses: (a) principle-based accounting standards are associated with higher analyst forecast errors; (b) managers’ earnings management incentives and a weak institutional environment exacerbate the negative impact of principle-based standards on analyst forecasts; and (c) analysts’ limited attention and effort aversion exacerbate the negative impact of principle-based standards on analyst forecasts.

Target population

Financial analysts, accounting standards setting bodies such as IASB and accounting regulators in emerging markets.

Adopted methodology

We used ordinary least squares regressions, archival data, and textual analysis methods to obtain the initial data.

Analyses

First, based on firms’ annual reports, we used text analysis methods to construct a firm-level principle-based measurement. Then, we examined the relationship between the degree of a firm’s reliance on principle-based standards and the analyst forecast errors. After obtaining the baseline result, we further discussed the possible mediating effects of accounting information quality and analysts’ subjective mindsets. Finally, we discussed the impact of principle-based standards on other forecasting attributes beyond analyst forecast errors.

Findings

Using a sample of Chinese listed firms, we found that analysts’ forecast errors are larger for firms that rely more on principle-based standards. Based on the “input-processing-output” model, we found that in the input stage, principle-based standards may become a tool for managers to manipulate accounting earnings in firms with stronger earnings management incentives or that are in weaker institutional environments, leading to higher analyst forecast error, with accounting information quality as an important mediator. During processing, analysts’ limited attention and effort aversion exacerbate the adverse impact of principle-based standards on forecast quality, while analysts’ experience can mitigate this effect. For output results, principle-based standards are also associated with higher forecast dispersion, longer forecast lag, and more forecast revisions. Collectively, our research uncovered some dark sides of principle-based standards in weak institutional environments.

Synopsis

The research problem

This study examined whether country-level loss aversion influences how investors respond to earnings news. Specifically, I examined the stock price sensitivity to negative earnings news vis-à-vis positive earnings news.

Motivation

Investor expectations about the amount, timing, and uncertainty of future cash flows largely determine a firm’s stock price. An earnings announcement’s primary role is to update expectations, which in turn leads to an update in firms’ stock prices. Historically, researchers have assumed an efficient and unbiased valuation process. However, the last quarter century has seen advances in areas such as behavioral finance that raise the question of under which conditions these assumptions no longer hold. This study investigated the role of investor loss aversion in the market response to negative and positive earnings news.

The test hypotheses

The first hypothesis is that country-level loss aversion is positively associated with the market response to negative earnings news. Second, country-level loss aversion is negatively associated with the market response to positive earnings news. Third, these associations are moderated by a country’s degree of short-term orientation, restraint vs. indulgence, power distance, and rule of law.

Target population

The target population includes all available publicly traded companies.

Adopted methodology

I used OLS on a pooled sample of archival data.

Analyses

I examined 266,630 annual earnings announcements across 45 countries from 1988 to 2021. I identified country-level loss aversion with two recently developed measures and ascertained investors’ sensitivity to earnings news using earnings response coefficients (ERCs) at both the pooled and country level. ERCs highlight how short-window stock returns covary with earnings news.

Findings

The results indicated that investors are more sensitive to bad earnings news in more loss-averse countries. In contrast, investor sensitivity to good earnings news is generally unassociated with loss aversion. Further analysis indicated that a subsequent return drift to extreme bad news is present among low-loss-aversion countries but not high-loss-aversion countries, suggesting that loss-averse investors more fully incorporate bad earnings news into stock prices. In contrast, the return drift to extreme positive news is detectable regardless of the level of loss aversion. The influence of loss aversion is more pronounced in countries with a short-term orientation and in countries characterized as more restrained.