Nemit Shroff

Externalities of Public Firm Presence: Evidence from Private Firms’ Investment Decisions

Public firms provide a large amount of information through their disclosures. In addition, information intermediaries publicly analyze, discuss and disseminate these disclosures. Thus, greater public firm presence in an industry should reduce uncertainty in that industry. Following the theoretical prediction of investment under uncertainty, we hypothesize and find that private firms are more responsive to their investment opportunities when they operate in industries with greater public firm presence. Further, we find that the effect of public firm presence is greater in industries with better information quality and in industries characterized by a greater degree of investment irreversibility. Our results suggest that public firms generate positive externalities by reducing industry uncertainty and facilitating more efficient private firm investment.

Voluntary Disclosure and Information Asymmetry: Evidence from the 2005 Securities Offering Reform

In 2005, the SEC enacted the Securities Offering Reform (Reform), which relaxes ‘gun jumping’ restrictions, thereby allowing firms to more freely disclose information before equity offerings. We examine the effect of the Reform on voluntary disclosure behavior before equity offerings and the associated economic consequences. We find that firms provide significantly more preoffering disclosures after the Reform. Further, we find that these pre-offering disclosures are associated with a decrease in information asymmetry and a reduction in the cost of raising equity capital. Our findings not only inform the debate on the market effect of the Reform, but also speak to the literature on the relation between voluntary disclosure and information asymmetry by examining the effect of quasi-exogenous changes in voluntary disclosure on information asymmetry, and thus a firm’s cost of capital. JEL Classification: G14; M41

Corporate Investment and Changes in GAAP

This paper investigates whether changes in Generally Accepted Accounting Principles (GAAP) affect corporate investment decisions. Using a sample containing forty nine changes in GAAP, I find that changes in accounting rules affect investment decisions. I then examine two mechanisms through which changes in GAAP affect investment. First, I find that changes in GAAP affect investment, particularly R&D expenditures, when firms have financial covenants that are affected by changes in GAAP. Second, I find evidence suggesting that the process of complying with some changes in GAAP alters managers’ information sets and consequently changes their investment decisions, particularly their capital and R&D expenditures and, to a weaker extent, their acquistion expenditures. This paper contributes to the literature on the real effects of accounting by providing evidence that accounting rules affect investment decisions even when the rule change does not concern the measurement and reporting of investment, and by documenting specific mechanisms through which the relation manifests.This paper investigates whether mandatory changes in Generally Accepted Accounting Principles (GAAP) affect managerial investments in physical capital and research and development. Using a sample containing forty–nine changes in GAAP, I find evidence that changes in accounting rules affect investment decisions. I then examine two mechanisms through which changes in GAAP affect investment. First, I show that the process of complying with certain mandatory changes in financial reporting alters managers’ information sets and consequently changes the quality of their investment decisions. Second, I show that managers of firms with financial covenants likely to be affected by changes in GAAP invest more (less) when the change in GAAP increases (decreases) covenant slack. This paper contributes to the literature on the real effects of accounting by showing that accounting rules affect investment decisions and by documenting specific mechanisms through which the relation manifests.

The Impact of Ambiguity on Managerial Investment and Cash Holdings

Standard finance theory suggests that managers invest in projects that, in expectation, produce returns that justify the use of capital. An underlying assumption is that managers have the information necessary to understand the distributional properties of the pay-offs underlying the decision. This paper examines firm investment behavior when managers are likely to find it more challenging to develop expectations of pay-offs, namely during periods of increased macroeconomic ambiguity. In particular, we examine how macroeconomic ambiguity – proxied by the variance premium (Drechsler, ) and the dispersion in forecasts of corporate profits from the Survey of Professional Forecasters (Anderson et al., ) – impacts managerial capital investment and cash holdings. Consistent with ambiguity theory, we find that macroeconomic ambiguity is negatively associated with capital investment and positively associated with cash holdings. These results are robust to alternative explanations related to risk, investor sentiment and economic conditions. Moreover, consistent with recent theoretical real options literature, we find that ambiguity reduces the value of investment opportunities, while risk increases the value of such opportunities. Overall, these findings provide initial empirical evidence on the economic distinction between ambiguity and risk with respect to managerial investment and cash holdings.

Corporate investment and changes in GAAP

This paper investigates whether changes in Generally Accepted Accounting Principles (GAAP) affect corporate investment decisions. Using a sample containing forty nine changes in GAAP, I find that changes in accounting rules affect investment decisions. I then examine two mechanisms through which changes in GAAP affect investment. First, I find that changes in GAAP affect investment, particularly R&D expenditures, when firms have financial covenants that are affected by changes in GAAP. Second, I find evidence suggesting that the process of complying with some changes in GAAP alters managers’ information sets and consequently changes their investment decisions, particularly their capital and R&D expenditures and, to a weaker extent, their acquistion expenditures. This paper contributes to the literature on the real effects of accounting by providing evidence that accounting rules affect investment decisions even when the rule change does not concern the measurement and reporting of investment, and by documenting specific mechanisms through which the relation manifests.

Why regulate private firm disclosure and auditing

Private firms face differing financial disclosure and auditing regulations around the world. In the US and Canada, for example, private firms are generally neither required to disclose their financial results nor have their financial statements audited. By contrast, many firms with limited liability in most other countries are required to file at least some financial information publicly and are also required to have their financial statements audited. This paper discusses and analyzes the reasons for differential financial reporting regulation of private firms. We first discuss various definitions of a private firm. Next, we examine theoretical arguments for regulating the financial reporting of these firms, particularly related to public disclosure and auditing. We then provide new survey-based evidence of firms’ and standard setters’ views of regulation. We conclude by identifying future research opportunities.

Does Auditor Regulatory Oversight Affect Corporate Financing and Investment Decisions

This paper examines the effect of the Public Company Accounting Oversight Board (PCAOB) international inspection program on companies’ financing and investing decisions. Estimates from difference-in-differences regressions suggest that companies respond to their auditor receiving a ‘deficiency-free’ inspection report by issuing additional external capital amounting to 1.4% of assets and increasing investment by 0.5% of assets. These effects are larger for (i) financially constrained companies and (ii) companies located in countries where there is no audit regulator or the audit regulator does not conduct inspections. Further, the effect on financing decisions is stronger in countries with (i) low corruption, (ii) strong rule of law, and (iii) high regulatory quality. Descriptive evidence suggests that inspections increase the use of financial covenants in debt contracts, which is likely one of the mechanisms through which inspections generate real effects. This paper documents the value of PCAOB inspections in mitigating financing frictions for non-U.S. companies.I examine whether financial reporting quality and credibility affect a company’s financing and investment decisions. I use PCAOB inspections of non-U.S. auditors as exogenous shocks to the reporting quality of non-U.S. companies audited by PCAOB inspected auditors. I then use the subsequent public revelation of the inspection as exogenous shocks to the reporting credibility of non-U.S. companies that employ PCAOB inspected auditors. Using a difference-indifferences design, I find that although PCAOB inspections improve accrual quality for non-U.S. companies audited by the inspected auditors, there is no evidence that these improvements in accrual quality lead to changes in investment, investment efficiency or debt financing. However, I find that when PCAOB inspection reports are subsequently made public, non-U.S. companies audited by PCAOB inspected auditors increase their long-term debt (investment) by 11.5% (10.9%) and become more responsive to their investment opportunities. These effects are stronger for financially constrained companies and companies with non-big four auditors. Overall, the evidence in this paper suggests that regulatory oversight of the auditor helps improve reporting credibility, which in turn facilitates corporate investment by increasing companies’ external financing capacity. I thank Daniel Aobdia, Beth Blankespoor, Lisa De Simone, Michelle Hanlon, Jonas Heese (discussant), Becky Lester, Rodrigo Verdi, and seminar participants at the Dartmouth Accounting Research Conference, PCAOB Center for Economic Analysis, Stanford University, and University of North Carolina for many helpful comments and suggestions. I thank Niketa Shroff for help with data collection. I gratefully acknowledge financial support from the MIT Junior Faculty Research Assistance Program. All errors are my own.

Tax Rates and Corporate Decision Making

We survey companies and find that many use incorrect tax rate inputs into important corporate decisions. Specifically, many companies use an average tax rate (the GAAP effective tax rate, ETR) to evaluate incremental decisions, rather than using the theoretically correct marginal tax rate. We find evidence consistent with behavioral biases (heuristics, salience) and managers’ educational backgrounds affecting these choices. We estimate the economic consequences of using the theoretically incorrect tax rate and find that using the ETR for capital structure decisions leads to suboptimal leverage choices and using the ETR in investment decisions makes firms less responsive to investment opportunities.

Financial Reporting Quality and Economic Growth

We investigate whether financial reporting quality facilitates economic growth. Our hypothesis is that better reporting quality improves project identification and selection, and lowers the cost of capital, translating into faster growth. Based on the premise that information uncertainty exacerbates decision making difficulty and agency problems, and that reporting quality mitigates these problems, we predict and find that high information uncertainty industries grow disproportionately faster in countries with better reporting quality. Specifically, we find that high information uncertainty industries grow between 0.12% and 0.22% faster in countries with high reporting quality. Additional evidence using International Financial Reporting Standards (IFRS) as an exogenous shock to reporting quality supports our hypothesis.

When Does Peer Information Matter

This paper examines whether and when the information environment of peer firms in an industry affects the cost of capital for other firms in the industry. We predict and find that the peer information environment is negatively associated with a firms cost of capital when there is less publicly available firm-specific information and this negative association shrinks as the amount of firm-specific information increases. This paper provides evidence that information about peer-firms has externalities on the cost of capital for related firms and that these externalities are time-varying.