In March, the Public Company Accounting Oversight Board held hearings about whether to require public companies to change — or “rotate” — their external auditor periodically. Meanwhile, the European Union is proposing to require mandatory rotation every six or 12 years, and the lower house of the Dutch Parliament recently voted to require auditor rotation every eight years.

At the PCAOB hearings, various investor advocates and pension funds argued in favor of mandatory rotation. They found fault with the lengthy relationships between many auditors and the companies they audit — the auditors of almost 36% of all companies in the Russell 1000 have held that position for 21 years or more. According to the supporters of auditor rotation, this coziness creates a potential conflict of interest: an auditor’s desire to maintain a good relationship with its client could conflict with its duty to rigorously question the client’s financial statements.

Mandatory auditor rotation could reduce this conflict. Since auditors would know that their engagement would come to an end after a fixed period, they would have less incentive to curry favor with management. At the same time, mandatory rotation could encourage existing auditors to perform more thorough audits, because the firm would fear that a new auditor would expose any previous errors or omissions.

…continue reading: Search for Auditors; Don’t Rotate

In the paper, Tailspotting: How Disclosure, Stock Prices and Volatility Change When CEOs Fly to Their Vacation Homes, which was recently made publicly available on SSRN, I document a close connection between the timing of corporate news disclosures and CEOs’ personal vacation schedules. I find that companies tend to disclose favorable news just before CEOs leave for vacation and then hold over subsequent news announcements until they return to headquarters. During periods when CEOs are away from the office, stock prices behave quietly with sharply lower volatility than usual. Volatility increases immediately when CEOs return to work. I identify CEO vacation trips by merging publicly available flight histories of corporate jets with on-line real estate records that indicate locations where CEOs own vacation residences, often in upscale oceanfront communities in Florida or New England or close to golf or ski resorts.

For example, on January 7, 2010, aerospace manufacturer Boeing Co. disclosed a 28% increase in annual commercial airliner deliveries and also issued an earnings forecast for the year ahead. Boeing stock rose 4%, capping three days in which it outperformed the market by almost 10%. The company’s shares were quiet for the next several weeks, not moving significantly again until January 27, when Boeing announced strong quarterly earnings and its stock rose more than 7%. In between these announcements, Boeing’s CEO appears to have been on vacation, an inference based upon Federal Aviation Administration (FAA) records of company aircraft trips to and from an airport near his vacation home in Hobe Sound, FL. During this vacation period, the annualized volatility of Boeing’s stock dropped to 0.16, an unusually low level for a major blue chip. During the three days before and three days after his trip, the volatility was more than twice as high at 0.40.

…continue reading: Tailspotting

The Public Company Accounting Oversight Board is proposing a new auditing standard that relates to the auditor’s evaluation of a company’s relationships and transactions with related parties, and amendments to existing auditing standards that relate to significant unusual transactions and financial relationships and transactions by a company with its executive officers (including incentive compensation arrangements). The new and amended standards are intended to focus auditors’ efforts on areas that may pose an increased risk of material misstatement to a company’s financial statements.

The PCAOB’s proposals largely build upon and enhance existing requirements in these areas, primarily by providing greater specificity around the procedures that must be employed and inquiries that must be made. While the proposals would not directly impact the non-financial-statement disclosure (such as proxy disclosure) relating to related party transactions and executive compensation under SEC rules, companies should anticipate greater auditor focus and additional audit procedures on the financial statement impact of these areas if these proposals are adopted.

Subject to SEC approval, the new and amended standards would be effective for audits of financial statements for fiscal years beginning on or after December 15, 2012. The deadline for public comment is May 15, 2012.

…continue reading: New PCAOB Auditing Standards

It is an honor for me to participate in the Public Company Oversight Board’s public meeting to discuss proposals to enhance auditor independence, objectivity and professional skepticism, including the potential of imposing rules setting a maximum term limit for audit relationships. Sadly, many people in official Washington seem prepared to jettison the interests of investors without reason as would occur in the proposed JOBS legislation, which as currently written would unnecessarily savage important barriers against fraud and manipulation of markets. We should never be afraid to experiment with opportunities for reducing unnecessary regulatory costs, particularly for smaller companies. At the same time, we shouldn’t let anyone’s financial agenda be a pretext for allowing the unscrupulous a free rein to abuse savers and investors. In its current form this legislation has too many elements that are simply fantasies, such as that a company with $1 billion in revenue is a “small business”, when that is 10-20X too high a threshold.

When Jim Doty and I were at the SEC, the Commission created an entire set of registration statements and ’34 Act filings (eg, Form 10-KSB) geared for small companies to lower their costs in raising capital or being public companies. Companies could elect the simpler forms if they wished, although they might pay a market penalty for providing less information. We allowed things like requiring two years of audited financials rather than 3 years, and three years rather than five years of selected financial data. We simplified disclosure requirements for smaller firms with less than $25mm in revenue (about $41mm in today’s dollars), but nobody got a free pass for fraud and there was still transparency for investors in current results.

…continue reading: Proposals for Auditor Independence and Audit Firm Rotation

In our forthcoming Journal of Accounting Research paper, Equity Risk Incentives and Corporate Tax Aggressiveness, we examine equity risk incentives as one determinant of corporate tax aggressiveness. As noted by Shevlin [2007], we have an incomplete understanding of why some firms are more tax aggressive than others. Prior accounting research finds that corporate tax avoidance is systematically associated with certain firm attributes, including profitability, extent of foreign operations, intangible assets, research and development expenditures (R&D), leverage, and financial reporting aggressiveness. Dyreng, Hanlon, and Maydew [2010] conclude that individual managers influence their firms’ tax avoidance, even after controlling for numerous firm characteristics. Prior research also examines whether income tax avoidance is associated with corporate compensation practices, but finds mixed evidence. We argue that tax avoidance is a risky activity, which imposes costs on both firms and managers. As a result, managers must be incentivized to engage in tax avoidance that involves uncertain outcomes.

Equity risk incentives capture the convexity of the relation between a manager’s wealth and stock price, and are measured as the change in value of a manager’s stock option portfolio for a given change in stock return volatility (e.g., Guay [1999]). In short, equity risk incentives reflect how changes in stock return volatility affect managerial wealth. Prior research provides evidence that equity risk incentives motivate managers to make more risky – but positive net present value – investing and financing decisions. However, these studies do not examine the relation between equity risk incentives and risky tax planning, which we also refer to as “risky tax avoidance” and/or “aggressive tax positions.” We argue that just as equity risk incentives motivate managers to make more risky investing and financing decisions, they also motivate managers to undertake more aggressive (i.e., risky) tax positions, and thus account for some variation in tax aggressiveness across firms.

…continue reading: Equity Risk Incentives and Corporate Tax Aggressiveness

It is well known that the separation of ownership and control in public firms causes tension between investors and managers. These so-called “agency problems” are particularly pronounced in the use of corporate cash holdings because it is both easy for managers to misuse cash and hard for investors to evaluate the appropriateness of mangers’ use of cash. Moreover, cash holdings account for a substantial proportion of corporate assets (about 25% of total assets in recent years). Therefore, since firms with better internal corporate governance tend to use their cash holdings more for the benefit of their investors rather than their managers, it is not surprising that investors are willing to pay a higher price for them.

In the paper, Investor Horizons and Corporate Cash Holdings, which was recently made publicly available on SSRN, we study how the investment horizons of a firm’s institutional investors affect the agency costs of corporate cash holdings. It is widely recognized that monitoring by institutional investors of managers increases firm value. However, not all institutional investors are created equal, and, one important way in which they differ is their investment horizons. Differences in investment horizons arise, for example, because of differences in investment strategies (e.g., short-term hedge funds) and/or differences in the maturity of liabilities (e.g., long-term pension funds).

…continue reading: Investor Horizons and Corporate Cash Holdings

In our paper, Insider Trading Restrictions and Insiders’ Supply of Information: Evidence from Reporting Quality, which was recently made publicly available on SSRN, we exploit a natural experiment involving first-time enforcement of insider trading laws around the world in order to examine the impact of insider trading restrictions on insiders’ supply of information. Following the existing literature, we measure the quality of financial reporting along four dimensions: earnings smoothing, earnings management towards positive earnings, loss recognition, and value relevance.

Empirical analyses indicate that reporting quality improves following a country’s first-time enforcement of insider trading laws only in countries with strong macro governance infrastructure, suggesting that a country’s legal infrastructures play an important role in determining earnings quality. Consistent with the prediction that firm-level governance structures significantly affect insiders’ incentives and their responses to regulations, we also find that the improvement in earnings quality is concentrated in less closely held firms.

…continue reading: Insider Trading Restrictions and Insiders’ Supply of Information

In our paper, Mandatory IFRS Reporting and Changes in Enforcement, which was recently made publicly available on SSRN, we examine the underlying sources of the capital-market benefits around the introduction of mandatory IFRS reporting. Prior work finds significant capital market benefits and also shows that the effects around IFRS adoption are significantly stronger in countries with stricter and better functioning legal systems, and that they are stronger in the EU than in other regions of the world. We argue that this evidence is consistent with several interpretations and that it is still an open question to what extent these positive effects around mandatory IFRS adoption are indeed attributable to the switch to arguably better, more capital-market oriented, and globally harmonized accounting standards.

We focus on market liquidity and rely on within- and across-country variation in the timing of IFRS adoption and of other institutional changes to disentangle several possible explanations. Specifically, we explore whether (i) the switch from local GAAP to IFRS reporting played a primary role for the observed capital-market benefits; (ii) the introduction of IFRS had capital-market benefits, but only in countries with strong institutions and legal enforcement; or (iii) the switch to IFRS reporting itself had little or no effect and, instead, concurrent changes to countries’ institutions drive the observed capital-market benefits.

…continue reading: Mandatory IFRS Reporting and Changes in Enforcement

A year has passed since Wachtell, Lipton, Rosen & Katz submitted a petition to the U.S. Securities and Exchange Commission requesting that it update its Schedule 13D reporting requirements to “clos[e] the Schedule 13D ten-day window between crossing the 5 percent disclosure threshold and the initial filing deadline, and adopt[] a broadened definition of ‘beneficial ownership’ to fully encompass alternative ownership mechanisms.” As the petition noted: “Recent maneuvers by activist investors both in the U.S. and abroad have demonstrated the extent to which current reporting gaps may be exploited, to the detriment of issuers, other investors, and the market as a whole.” [1] The SEC is scheduled to issue a concept release later this spring addressing the concerns raised by the petition. Activist hedge funds have responded strongly—opposing changes to the current Schedule 13D rules—complaining that the suggested changes will significantly hurt their business. Regardless of whether the present reporting scheme allows activist investors to profit by keeping their accumulations secret, it is clear that the present reporting regime is outdated and needs to be reconsidered. At a time when the SEC is requiring greater transparency from public companies and their executives, the same policy concerns demand greater transparency with respect to the acquisition of equity securities of public companies by third parties.

…continue reading: Section 13(d) Reporting Requirements Need Updating

In our forthcoming Journal of Financial Economics paper, Stock Options and Managerial Incentives for Risk Taking, we exploit the change in the accounting treatment of stock-based compensation under FAS 123R, which was issued by the Financial Accounting Standards Board (FASB) and took effect in December 2005, to provide new evidence on the role that convexity in compensation contracts plays in providing incentives for risk taking by managers.  An additional rationale that is often stated for the dramatic rise in option-based compensation over time revolves around how stock options were treated for accounting purposes. Prior to the implementation of FAS 123R, firms were allowed to expense stock options at their intrinsic value. Because nearly all firms granted stock options at-the-money, no expenses for option-based compensation were generally reported on the income statement.

Hall and Murphy (2003) argue that, due to their favorable accounting treatment and the fact that there is no cash outlay at the time of the grant, firms act as though the perceived cost of options is lower than their true economic cost. If firms make decisions based on the perceived costs instead of the economic costs, they grant more options than they would otherwise, and options with their favorable accounting treatment are preferred to possibly better incentive plans with less favorable accounting treatment. Consistent with this view, Carter, Lynch, and Tuna (2007) provide evidence that the accounting treatment of stock options affected their use, showing that a comprehensive proxy for financial reporting concerns was positively related to the use of stock options prior to FAS 123R. The implementation of FAS 123R eliminated the ability to expense options at their intrinsic value and instead required firms to begin expensing stock-based compensation at its fair value, effectively eliminating any accounting advantages associated with stock options.

…continue reading: Stock Options and Managerial Incentives for Risk Taking