Linda A. Myers

Does Company Reputation Matter for Financial Reporting Quality? Evidence from Restatements

In this study, we explore the association between company reputation and the likelihood of a financial statement restatement (i.e., a revealed misstatement). We focus on restatements because they are one of the most visible forms of impaired financial reporting quality, and we suggest that company reputation concerns will influence the reporting process and reduce financial statement misstatements (and ultimately restatements). We proxy for company reputation using measures based on Fortune’s America’s Most Admired Companies List. For a sample of 8,081 observations from 1995 through 2009, we find that companies with higher reputation scores are less likely to misstate their financial statements after controlling for CEO tenure, corporate governance, and audit fees (a proxy for audit effort). In addition, we find that companies with higher reputations have better accruals quality. We also find that company reputation is positively associated with audit fees even after controlling for corporate governance. These results are consistent with company reputation having an important effect on financial reporting quality and with the effect of reputation being distinct from that of corporate governance.

Disclosure Quality and the Mispricing of Accruals and Cash Flow

In this paper, we investigate the role that disclosure quality plays in the accurate valuation of accruals and cash flow. We predict that stock prices of firms with higher-quality disclosures more accurately reflect the persistence of accruals and cash flow. We test our predictions using analyst ratings of disclosure published in the annual Association for Investment Management and Research (AIMR) Corporate Information Committee Reports for the years 1982 through 1996. The results provide strong evidence of mispricing for the subset of firms with lower-quality disclosures and of a significant reduction in mispricing for the subset of firms with higher-quality disclosures. We confirm the results of our Mishkin tests using returns regressions that also control for investor sophistication, analyst following, and firm life cycle stage. Overall, our results demonstrate the mitigating effect that higher-quality disclosure has on mispricing.

Company reputation and the cost of equity capital

In this study, we investigate whether companies with better reputations enjoy a lower cost of equity financing. Using a sample of 9,276 large U.S. companies from 1987 through 2011 and the reputation rankings from Fortune’s “America’s Most Admired Companies List�?, we find strong evidence that companies with higher reputation scores enjoy a lower cost of equity capital even after controlling for other factors that determine the cost of equity. In addition, we find that the effect of reputation on the cost of equity increases with the degree of information asymmetry, consistent with the reputation rankings providing information about company quality. We also find that changes in reputation are associated with subsequent changes in the company’s investor base, consistent with reputation rankings affecting investor recognition and improving risk sharing. We contribute to the cost of capital literature by identifying a unique determinant of the cost of equity, and to the reputation literature by demonstrating an important benefit that derives from creating and maintaining a high reputation.

Short Selling Around Restatement Announcements When Do Bears Pounce

This paper draws on two distinct literatures – one that investigates the impact of accounting restatements and another that investigates the trading behavior of short sellers – to further our understanding of how sophisticated investors process and respond to news about accounting corrections. We examine short-seller behavior in the days surrounding restatement announcements to determine when short sellers identify restatements and how they trade on restatement news. Our findings suggest that short sellers do not appear to anticipate restatement announcement dates, but we find that abnormal short selling is significantly higher than is typical when restatements are announced, especially for restatements announced transparently (i.e., in press releases or 8-Ks). Short sellers target small companies, whose information environments may be weaker, and companies making restatements that reduce previously reported income. In addition, we find that restating companies targeted most heavily by short sellers experience the most negative subsequent abnormal returns over horizons of up to 40 trading days following the restatement disclosure. Overall, our results suggest that short sellers respond to, but do not anticipate, restatement announcements and trade as if they understand the post-announcement stock price implications of restatement disclosures.

Short Selling Around Restatement Announcements

This article draws on two distinct literatures—one that investigates the impact of accounting restatements and another that investigates the trading behavior of short sellers—to further our understanding of how sophisticated investors process and respond to news about accounting corrections. We examine short-seller behavior in the days surrounding restatement announcements to determine when short sellers identify restatements and how they trade on restatement news. Our findings suggest that short sellers do not appear to anticipate restatement announcement dates, but we find that abnormal short selling is significantly higher than is typical when restatements are announced, especially for restatements announced transparently (i.e., in press releases or 8-Ks). Short sellers target small companies, whose information environments may be weaker, and companies making restatements that reduce previously reported income. In addition, we find that restating companies targeted most heavily by short sellers experience the most negative subsequent abnormal returns over horizons of up to 40 trading days following the restatement disclosure. Overall, our results suggest that short sellers respond to, but do not anticipate, restatement announcements and trade as if they understand the post-announcement stock price implications of restatement disclosures.

Does the Timing of Auditor Changes Affect Audit Quality? Evidence from the Initial Year of the Audit Engagement

We focus on the first year of the auditor-client relationship and investigate whether audit quality varies with the timing of the new auditor’s appointment. We find that audit quality is not lower for companies that engage new auditors before the end of the third fiscal quarter than for companies that do not change auditors. However, companies that engage new auditors during or after the fourth fiscal quarter are more likely to misstate their audited financial statements than companies that engage new auditors earlier in the year and companies that do not change auditors. In additional tests, we find that the decrease in audit quality associated with late auditor changes is more pronounced for companies with complex operations (i.e., more operating segments). These results suggest that the extent to which audit quality suffers in the first year of audit engagements is affected by both the amount of time required to understand the client’s business, assess risks, and perform the audit (all of which are driven by client complexity), as well as the amount of time available for auditors to perform these tasks.

Are Liquidity Improvements Around the Mandatory Adoption of IFRS Attributable to Comparability Effects or to Quality Effects

Using a treatment sample of more than 5,000 firms from 22 countries that required reporting under International Financial Reporting Standards (IFRS) on or before fiscal 2005, we find an increase in aggregate market liquidity around mandatory IFRS reporting. We examine whether the positive market effect on liquidity of mandatory IFRS reporting is attributable to the convergence of diverse accounting standards into a single set of accounting standards (i.e., Comparability Effects), to improved financial reporting quality (i.e., Quality Effects), or both. We find evidence suggesting that liquidity improvements are attributable to increased comparability. In addition, we find that the Quality Effect around the IFRS mandate is generally negative, suggesting that the markets in our sample behave as if the mandatory adoption of IFRS will not increase financial reporting quality (beyond domestic generally accepted accounting principles) in most sample countries.

Do Accounting Firm Consulting Revenues Affect Audit Quality? Evidence from the Pre- and Post-SOX Eras

The Big 4 accounting firms have experienced a steady increase in the proportion of their revenues generated by providing consulting services post-SOX, primarily to nonaudit clients. Regulators have expressed concerns about the potential implications of this increase for audit quality. In contrast, the accounting firms assert that the expertise developed by their consulting professionals helps them to provide better quality audits. We examine the relation between the proportion of accounting firm consulting revenue to total revenue and audit quality, measured using financial statement misstatements. Our results suggest that, on average, higher consulting revenues are not associated with impaired audit quality. However, higher consulting revenues are associated with reduced audit quality among clients with lower litigation risk. These results support the argument that a cultural shift associated with the provision of more consulting services, even to nonaudit clients, can adversely affect audit quality in some circumstances (e.g., when litigation risk-related incentives for high audit quality are weaker). In addition, although the effect of higher consulting revenues only impacts audit quality among low litigation risk clients, results of earnings response coefficient tests suggest that investors perceive a deterioration in audit quality when a higher proportion of accounting firm revenue is generated from consulting services regardless of the client’s level of litigation risk. These results suggest that regulator and investor concerns about the provision of consulting services (at least at the levels we observe) may be warranted, but only among clients where opposing incentives to provide high audit quality are weaker.

Financial Statement Comparability and the Informativeness of Stock Prices About Future Earnings

We find that financial statement comparability enhances the ability of current period returns to reflect future earnings, as measured by the future earnings response coefficient (FERC). Thus, comparability improves the informativeness of stock prices and allows investors to better anticipate future firm performance. In addition, using both the FERC and stock price synchronicity tests, we find that comparability increases the amount of firm-specific information (rather than market / industry-level information) reflected in stock prices. Moreover, analysts play an important role in improving the ability of stock prices to incorporate firm-specific information because they produce more firm-specific information when comparability is higher.

Venture Capital and Material Weaknesses in Internal Control

The Sarbanes-Oxley Act requires management and board of directors to be involved in establishing and maintaining good quality internal control systems and the evaluation and disclosure of any deficiencies or weaknesses that could potentially result in a material error. We find that venture capital backing is negatively associated with disclosures of material weaknesses in internal control. We show that material weakness disclosure is much more likely to be informative for firms backed by VCs: material weakness disclosure is followed by subsequent financial restatements for VC-backed firms, but not other firms. Furthermore, we find that firms backed by more reputable VCs have more effective controls as evaluated by management and auditors.