Yinqi Zhang

Effect of R&D investments on persistence of abnormal earnings

Purpose – This paper sets out to test the effects of firms’ and industrys R&D intensity on persistence of abnormal earnings. Design/methodology/approach – Ohlsons valuation model is used with pooled regressions along with Fama–Macbeth methodology on yearly regressions and partitioning on Herfindahl index to conduct the tests. Findings – It was found that firms’ and industries’ R&D intensities are both positively correlated with persistence of abnormal earnings. The evidence suggests that the positive effect on earnings persistence caused by R&Ds effectiveness in mitigating competition dominates the negative effect brought by more risk from R&D projects Practical implications – The fact that the firms own R&D investment leads to incremental earnings persistence beyond that of the industry suggests the importance of incorporating both industry and firms R&D intensity in earnings persistence. While industry R&D investment leads to competition mitigation via creation of entry barriers, a firms own investment in R&D differentiates its products from those of its competitors, and thereby results in further competition mitigation by creating replacement barriers. Originality/value – Finally, since R&D intensity is correlated with earnings persistence, inclusion of R&D intensity in future earnings persistence studies may lead to better model specification by reducing the problem of correlated omitted variables.

Is There a Relation between Audit Fee Cuts During the Global Financial Crisis and Banks’ Financial Reporting Quality?

As a result of the global financial crisis (GFC), several audit clients were able to negotiate lower audit fees for the years 2008 and 2009. However, the PCAOB has expressed concern that lower audit fees might lead to lower audit effort and lower audit quality and financial reporting quality. This study examines the relation between audit fee cuts and banks’ financial reporting quality. Specifically, we focus on earnings management via loan loss provisions (LLP), the relation between current period LLP and future loan charge-offs, i.e., LLP validity, and the timely recognition of loan losses. For banks audited by Big 4 auditors, we find that income-increasing abnormal LLP are decreasing in audit fee cuts and LLP validity is increasing in audit fee cuts. For banks audited by non-Big 4 auditors, LLP validity is higher for banks that received a fee cut of more than 25 percent relative to other banks audited by non-Big 4 auditors. We do not observe an association between timely loan loss recognition and cuts in audit fees except for banks audited by non-Big 4 auditors and exempt from internal control audits where a fee cut of more than 25 percent is associated with less timely loan loss recognition. Overall, the findings suggest that Big 4 auditors constrained earnings management via LLP in banks that received cuts in audit fees. Our findings have important implications for regulators, investors, and others.

The Importance of Aggressive Tax Planning to the Diversion of Corporate Resources: Evidence from Chinese Public Firms

In measuring tunneling with inter-corporate loans disclosed by Chinese listed companies, we analyze the underlying channels through which aggressive tax planning facilitates the diversion of corporate resources by firm insiders. Using path analysis, we document that the path from tax aggressiveness to related loans is mediated by both the additional cash flows from tax savings and the increased financial opacity from tax planning, and that additional cash flows plays a much more important role than opacity at helping controlling shareholders to divert corporate resources under the guise of tax aggressiveness. Beyond the two mediated paths, we also detect a residual, direct path from tax aggressiveness to related loans. After the exogenous shock from the government crackdown on diversionary related loans, we find the direct path is fully mediated by the two indirect paths, suggesting that tunneling via related loans only occurs at firms where insiders can mask tunneling under the cover of opacity or can justify related loans on grounds of abnormal cash flows from tax savings. Our evidence supports the notion that greater outside scrutiny increases the hurdle for, but does not entirely eradicate, diversion facilitated by tax aggressiveness. Collectively, our research lends some support to recent theory on the importance of taxes to corporate governance by demonstrating how the agency costs of tax planning allow certain shareholders to benefit from firm activities at the expense of others.