Ananth Seetharaman

Litigation Risk and Audit Fees: Evidence from UK Firms Cross-Listed on US Markets

Two ingredients necessary to examine the relation between litigation risk and audit pricing are (a) a litigious legal environment, and (b) publicly disclosed auditor remuneration. We combine both ingredients by focusing on UK firms offering to sell their securities publicly in the United States. We find that UK auditors charge higher fees for their services when their clients access US, but not non-US, capital markets. Further, we show that the higher fees cannot be fully explained by the SECs extensive disclosure requirements. Rather, these findings are consistent with audit fees reflecting risk differences across liability regimes.

Tax-Related Financial Statement Restatements and Auditor-Provided Tax Services

In this study, the authors investigate the association between auditor-provided nonaudit tax services (NATS) and financial reporting quality for public companies in a post-Sarbanes-Oxley environment. They measure the quality of financial reporting by means of appropriately screened financial statement restatements. The Sarbanes-Oxley Act of 2002 (SOX) restricts the scope of auditor-provided tax services and simultaneously bans other major nonaudit services by the auditor. The authors argue that the restriction limits the potential financial reporting quality benefits of NATS, while the ban simultaneously makes those services a relatively more important source of revenue to the auditor, exacerbating the potential for impairment of independence. Consequently, pre-Sarbanes-Oxley results may not hold in a post-Sarbanes-Oxley environment. On examination, they find no significant association between auditor-provided NATS and general financial statement restatements. However, they find a significant negative association between such services and tax-related financial statement restatements. Thus, in a post-Sarbanes-Oxley environment, the benefits of auditor-provided NATS seem to manifest themselves in higher quality tax-related financial statement management assertions.

Analytical and Empirical Evidence of the Impact of Tax Rates on the Trade-off between Debt and Managerial Ownership

We show that, for a firm facing a high marginal tax rate, the benefit of using debt relative to managerial ownership to control agency costs increases at a decreasing rate. Debt and managerial stock ownership represent alternative mechanisms for reducing agency costs of the relationship between owner-investors and managers in firms. However, although debt and managerial ownership provide overlapping benefits, only debt can provide the differential benefit of reducing the firms tax liability. While the tax benefit from using debt relative to managerial ownership to control agency conflicts is an increasing function of the firms marginal tax rate, the decreased managerial ownership results in external investors bearing a larger part of the cost of debt that accrues to the firm. Effectively, for external investors, the relative cost of debt decreases at a decreasing rate when the marginal tax rate increases. Therefore, the trade-off between debt and managerial ownership predicted by the agency literature is expected to be strong at low marginal tax rates, but get progressively weaker at higher marginal tax rates. In this paper, we build an analytical model of this hypothesis and provide strong empirical evidence in its support. Our study contributes to a further understanding of how tax rates might affect the interaction of capital structure decisions with the incentive compatibility issues and corporate governance. The study also provides a basis for future studies to examine factors other than tax rates that differentially affect debt and managerial ownership costs.

An analysis of the distributional effects of replacing the progressive income tax with a flat tax

Abstract Our study investigates the distributional effects of replacing the current income tax system with two prototype flat tax systems: 1) the Armey-Shelby-Craig flat tax proposal, and 2) the Specter flat tax proposal. Our analysis indicates that replacing the current income tax system with either flat tax system would result in a modest increase in the average tax rate for taxpayers in the first income decile. For the remaining taxpayers, such a switch results in reductions in the average tax rate that tend to increase as income increases. We also found that for taxpayers reporting business income: 1) the current income tax system is most progressive, and 2) both flat tax systems are partially regressive. For taxpayers reporting no business income, however, the Armey-Shelby-Craig system is most progressive. Both flat tax proposals moderate before-tax income inequality modestly, but neithe moderates income inequality as effectively as the current income tax system.

Management Risk Incentives and the Readability of Corporate Disclosures

We show that managers with greater options vega undertake riskier firm policies and issue less readable corporate disclosures (Form 10-Ks). Ceteris paribus, a manager in the top quartile of vega files a Form 10-K that is 18.56% percent more voluminous than that of a bottom quartile vega manager. The effect of vega on disclosure obfuscation remains after controlling for firm risk, operating complexities and accounting choices, but is moderated by higher institutional ownership and greater shareholder rights, suggesting strategic disclosure obfuscation. These findings uncover a new (and unintended) link between incentive compatible compensation contracts and disclosure complexity.

The Effect of Regulatory Reforms on Institutional and Retail Investors: Evidence from Restatements before and after the Sarbanes-Oxley Act

Regulators have expressed concern that the growing number of financial restatements, especially since the passage of the Sarbanes-Oxley Act of 2002 (SOX), confuse investors and erode confidence in the capital markets. Given the investor protection goal of SOX, of particular concern is the relative accuracy with which retail investors process and trade on the information contained in restatement announcements. In this paper, we propose a method to examine the accuracy of the trading behavior of retail and institutional investors conditioned upon accounting restatement announcements, both prior- and subsequent to the passage of SOX. We find that retail investors engaged in more inaccurate (i.e., potentially loss-making) trades in the post-SOX period than in the pre-SOX period. In contrast, the accuracy of institutional investors’ trades does not show any significant difference between the pre- and post-SOX regimes. Our evidence suggests that retail (but not institutional) investors process post-SOX restatements more inaccurately than pre-SOX restatements.