Mark L. DeFond

Debt covenant violation and manipulation of accruals

Abstract This paper examines the abnormal accruals of a sample of 94 firms that reported debt covenant violations in annual reports. We expect debt covenant restrictions to influence accounting choices in the year preceding and the year of violation. Time-series and cross-sectional models are used to estimate ‘normal’ accruals. In the year prior to violation, both models indicate that ‘abnormal’ total and working capital accruals are significantly positive. In the year of violation, there is evidence of positive abnormal working capital accruals after controlling for management changes and auditor going concern qualifications.

Do Non-audit Service Fees Impair Auditor Independence? Evidence from Going-concern Audit Opinions

We find no significant association between non–audit service fees and impaired auditor independence, where auditor independence is surrogated by auditors’ propensity to issue going concern audit opinions. We also find no association between going concern opinions and either total fees or audit fees. In addition, our findings are robust to controlling for unexpected fees, to controlling for endogeneity among our variables, and to several alternative research design specifications. Our results are consistent with market–based incentives, such as loss of reputation and litigation costs, dominating the expected benefits from compromising auditor independence.

Does the Market Value Financial Expertise on Audit Committees of Boards of Directors

We examine three‐day cumulative abnormal returns around the announcement of 702 newly appointed outside directors assigned to audit committees during a period before implementation of the Sarbanes‐Oxley Act (SOX). Motivated by the SOX requirement that public companies disclose whether they have a financial expert on their audit committee, we test whether the market reacts favorably to the appointment of directors with financial expertise to the audit committee. In addition, because it is controversial whether SOX should define financial experts narrowly to include primarily accounting financial experts (as initially proposed) or more broadly to include nonaccounting financial experts (as ultimately passed), we separately examine appointments of each type of expert. We find a positive market reaction to the appointment of accounting financial experts assigned to audit committees but no reaction to nonaccounting financial experts assigned to audit committees, consistent with accounting‐based financial skills, but not broader financial skills, improving the audit committees ability to ensure high‐quality financial reporting. In addition, we find that this positive reaction is concentrated among firms with relatively strong corporate governance, consistent with accounting financial expertise complementing strong governance, possibly because strong governance helps channel the expertise toward enhancing shareholder value. Together, these findings are consistent with financial expertise on audit committees improving corporate governance but only when both the expert and the appointing firm possess characteristics that facilitate the effective use of the expertise.

Auditor changes and discretionary accruals

This paper examines accounting choice as reflected in the behavior of discretionary accruals for a sample of auditor change firms. Discretionary accruals are estimated around the time of the auditor change using a variation of the Jones (1991) technique. After controlling for several potentially confounding factors associated with auditor changes the paper finds that discretionary accruals are significantly income-decreasing during the last year with the predecessor auditor and not significantly different from zero during the first year with the successor auditor. In addition the difference in discretionary accruals between the last year with the predecessor and the first year with the successor is significantly income-increasing. The results also indicate there is no significant difference across sample partitions based on prior year audit opinions or Big Six membership of the predecessor and successor auditors.

Smoothing income in anticipation of future earnings

Abstract Recent theory argues that concern about job security creates an incentive for managers to smooth earnings in consideration of both current and future relative performance. We find support for this theory. Our evidence suggests that when current earnings are ‘poor’ and expected future earnings are ‘good’, managers ‘borrow’ earnings from the future for use in the current period. Conversely, when current earnings are ‘good’ and expected future earnings are ‘poor’ managers ‘save’ current earnings for possible use in the future. However, sensitivity analysis indicates that we cannot rule out selection bias as a potential alternative explanation for our findings.

Home Bias, Foreign Mutual Fund Holdings, and the Voluntary Adoption of International Accounting Standards

We test the assertion that a consequence of voluntarily adopting International Accounting Standards (IAS) is the enhanced ability to attract foreign capital. Using a unique database that reports firm-level holdings of over 25,000 mutual funds from around the world, our multivariate tests find that average foreign mutual fund ownership is significantly higher among IAS adopters. We also find that IAS adopters in poorer information environments and with lower visibility have higher levels of foreign investment, consistent with firms using IAS adoption to provide more information and/or information in a more familiar form to foreign investors. Taken together, our findings are consistent with voluntary IAS adoption reducing home bias among foreign investors and thereby improving capital allocation efficiency.

The effect of competition on CEO turnover

Abstract Relative performance evaluation (RPE) is likely to improve boards of directors ability to identify unfit CEOs, and competition is likely to enhance the usefulness of RPE. Consistent with our hypotheses, the frequency of CEO turnover is greater in highly competitive industries than in less competitive industries. We also find that RPE-based (firm-specific) accounting measures are more closely associated with CEO turnover in high (low) competition industries than in low (high) competition industries. These findings suggest that the lack of support for RPE in prior studies results from not considering the effects of competition.

An empirical analysis of analysts' cash flow forecasts

This study investigates the relatively recent and growing trend in analysts making operating cash flow forecasts. We find that cash flow forecasts are made for companies with accounting, operating and financing characteristics that are likely to make cash flows more helpful in interpreting earnings and assessing firm viability. Specifically, consistent with our expectations, we find that cash flow forecasts are more likely to be made for firms: (1) in industries with greater accounting choice heterogeneity; (2) with forecasted earnings losses;(3) with shorter operating cycles; (4) with greater capital intensity; and (5) with higher leverage. These findings suggest that market participants demand cash flow forecasts when cash flows are relatively more useful in assessing firm value. Supporting this explanation, we also find that analysts make cash flow forecasts when current cash flows have greater ability, and earnings have less ability, to predict future cash flows; when annual earnings have a lower association with stock returns; and when cash flow forecast errors are associated with stock returns around the earnings announcement date, but earnings forecast errors are not.

Voluntary Disclosure of Balance Sheet Information in Quarterly Earnings Announcements

We investigate a pervasive voluntary disclosure practice ? managers including balance sheets with quarterly earnings announcements. Consistent with expectations, we find that managers voluntarily disclose balance sheets when current earnings are relatively less informative, or when future earnings are relatively more uncertain. Specifically, balance sheet disclosures are more likely among firms: (1) in high technology industries; (2) reporting losses; (3) with larger forecast errors; (4) engaging in mergers or acquisitions; (5) that are younger; and (6) with more volatile stock returns. This is consistent with managers disclosing balance sheets in response to investor demand for value relevant information to supplement earnings.

The Riskiness of Large Audit Firm Client Portfolios and Changes in Audit Liability Regimes: Evidence from the U.S. Audit Market Discussion of "The Riskiness of Large Audit Firm Client Portfolios and Changes in Audit Liability Regimes: Evidence from the U.S. Audit Market"

We investigate whether the financial riskiness of large US audit firm clienteles varied with the changing audit litigation liability environment during the period 1975-1999. Partitioning the period of study into four distinct periods [a benchmark period (1975-1984), a period of increasing concerns about litigation liability (1985-1989), a period of lobbying for reform (1990-1994) and a post-relief period (1995-1999)], we find some evidence of risk decreases during 1985-1989, strong evidence of risk decreases during 1990-1994 and strong evidence of risk increases during 1995-1999. However, we also find that over the period of our study, a time during which Big Six market shares grew appreciably, the proportion of litigious-industry clients in Big Six client portfolios grew at about the same rate as the proportion of such clients in the population. Moreover, the Big Six share of the financially riskiest clients in the economy did not grow as fast as overall Big Six market share. In sum, while our evidence is consistent with the hypothesis that the riskiness of Big Six client portfolios responded to changes in the audit litigation liability environment, we find no systematic evidence of a race to the bottom or bottom fishing by these firms in a bid to increase their market shares.