Sharon P. Katz

Public Equity and Audit Pricing in the United States

To what degree are audit fees for U.S. firms with publicly traded equity higher than fees for otherwise similar firms with private equity? The answer is potentially important for evaluating regulatory regime design efficiency and for understanding audit demand and production economics. For U.S. firms with publicly traded debt, we hold constant the regulatory regime, including mandated issuer reporting and auditor responsibilities. We vary equity ownership and thus public securities market contextual factors, including any related public firm audit fees from increased audit effort to reduce audit litigation risk and/or pure litigation risk premium (litigation channel effects). In cross‐section, we find that audit fees for public equity firms are 20–22% higher than fees for otherwise similar private equity firms. Time‐series comparisons for firms that change ownership status yield larger percentage fee increases (decreases) for those going public (private). Results are consistent with litigation channel effects giving rise to substantial incremental audit fees for U.S. firms with public equity ownership.

The Changing Relevance of Accounting Information to Debt Holders over Time

We examine the change over time in the information content of accounting numbers from the perspective of bondholders and the causes for this change. Using proprietary longitudinal data, we find that, in contrast to the decline in the information content of accounting numbers to equity holders over time, the information content to bondholders has held steady or risen. The rise is attributable to economic factors such as an increase in risk and in the frequency of unfavorable news to which the valuation of debt is more sensitive than that of equity. There are indications, however, that reporting factors, specifically an increase in conservatism over the last four decades, is associated with this rise. The findings contribute to the scant literature on the use of financial information by bondholders and the extent to which financial reporting meets their unique information needs. Given debt holders prominence as users of financial statements, the findings have important implications for accounting standard setting.

Private Ownership and the Cost of Public Debt: Evidence from the Bond Market

A number of studies have examined the effect of public and private ownership on the cost of debt and concluded that the cost of debt of privately owned firms is higher, driven mainly by the poorer information environment in which these firms operate. We extend this strand of research in two ways. First, we identify and empirically establish the mechanisms that bring about a higher cost of debt to privately owned firms—namely, the limited access that these firms have to the equity capital market, their high rate of management and private-equity ownership, and their less conservative reporting. Second, we improve the reliability of the estimates of the effect of ownership type on the cost of debt by controlling for the different information environments in which privately and publicly owned firms operate. This is accomplished through the use of a sample consisting of publicly owned and privately owned firms that have public debt and are therefore subject to identical reporting and disclosure requirements. C...

Conforming Tax Avoidance and Capital Market Pressure

In this study we develop a measure of corporate tax avoidance that reduces both financial and taxable income, which we refer to as “book-tax conforming�? tax avoidance. We use simulation analyses, LIFO/FIFO inventory method conversions, and samples of private and public firms, to validate our measure of conforming tax avoidance. We then investigate the prevalence of conforming tax avoidance within a sample of public firms. Results from the validation tests indicate that our measure of conforming tax avoidance successfully captures book-tax conforming transactions and thus, variation in conforming tax avoidance across firms. Consistent with expectations, we also find that the extent to which public firms engage in conforming tax avoidance varies systematically with the capital market pressures to which they are subject. For example, public firms that lack analyst following, do not issue equity securities, report lower sales growth, or smaller discretionary accruals engage in relatively more conforming tax avoidance and less nonconforming tax avoidance. Our study develops a new measure of conforming tax avoidance that should be useful in future research and provides new insights on the extent to which public firms are willing to reduce income tax liabilities at the expense of reporting lower financial income.

Tax Avoidance and Future Profitability

Do firm managers invest the savings from tax avoidance in positive net present value projects that enhance future profitability or divert them towards perquisite consumption, rent extraction, and value destroying projects? We indirectly investigate this question by testing whether tax avoidance moderates the association between current and future profitability. Consistent with the negative implications of tax avoidance (e.g. rent extraction) we document that, on average, the main components of current profitability: margins, utilization of assets and operating liability leverage, result in lower future profitability for tax aggressive firms as compared to firms that are not tax aggressive. Further, the negative effect of lower margins is more robust and persistent than the impact of inefficient asset utilization and operating liability leverage. These results persist in various contexts that mitigate or exacerbate rent extraction, such as the existence of foreign operations, better governance structure, more transparency, industry leadership position, and across corporate life cycle stages.

Do Debt Covenants Unnecessarily Constrain Leverage? Evidence from SFAS 160

Prior evidence shows a reduction in leverage after covenant violations, but we do not know whether covenants affect leverage before they are violated. In this study, we use an exogenous accounting-based shock to debt covenants that relaxed covenant tightness (SFAS 160) and examine whether covenants constrain leverage for borrowers that are close to violation, even when the borrower is financially healthy. We find that SFAS 160 increased debt levels in firms that were close to violation. This increase in debt was driven by financially healthy firms, suggesting that the likelihood of future covenant violations could impede borrowing by firms. We also find an increase in investment sensitivity to Q after SFAS 160 in firms close to violation, suggesting the additional debt was used to make legitimate investments. Because SFAS 160 was passed in the midst of the financial crisis, it is difficult to generalize our findings to more normal financial periods.

Tax Avoidance and Dupont Measures of Future Performance

To date, there is mixed evidence on the implications of tax avoidance on firm value as measured by Tobin’s q or stock price reactions. The take-away from prior literature is that increased opportunities for rent extraction associated with tax avoidance (e.g., in low governance firms), might negatively affect the after-tax value of the firm. We revisit this topic by investigating the association between tax avoidance and firm fundamentals (leverage, profitability, and asset utilization), using DuPont analysis. We document that tax avoidance unambiguously lowers future pretax accounting rates of return (i.e., return on equity, return on net operating assets, and return on operating assets), largely due to inefficient utilization of operating assets and operating liabilities. These results also hold in different contexts that mitigate rent extraction, including when firms have foreign operations and good governance.