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Abstract:
This paper examines whether auditor fees are associated with earnings management and the market reaction to the disclosure of auditor fees. Using data collected from proxy statements, we present evidence that non-audit fees are positively associated with small positive earnings surprises, the magnitude of absolute discretionary accruals, and the magnitude of income-increasing and income-decreasing discretionary accruals. In contrast, audit fees are negatively associated with these earnings management indicators. These results are robust to a variety of alternative variable definitions and model specifications. Specifically, contrary to the claims of Ashbaugh et al. (2002), the results are robust to the use of performance-matched discretionary accruals. Moreover, contrary to the claims of Francis and Ke (2002), the results for small positive earnings surprises are robust regardless of whether the comparison group is all other earnings surprises or small negative earnings surprises. Our final set of results provide evidence of a significant negative association between non-audit fees and share values on the date the fees were disclosed, although the effect is small in economic terms.

auditor independence, auditor fees, earnings management, discretionary accruals

Abstract:
This paper examines whether auditor fees are associated with earnings management and the market reaction to the disclosure of auditor fees. Using data collected from proxy statements, we present evidence that non-audit fees are positively associated with small positive earnings surprises, the magnitude of absolute discretionary accruals, and the magnitude of income-increasing and income-decreasing discretionary accruals. In contrast, audit fees are negatively associated with these earnings management indicators. These results are robust to a variety of alternative variable definitions and model specifications. Specifically, contrary to the claims of Ashbaugh et al. (2002), the results are robust to the use of performance-matched discretionary accruals. Moreover, contrary to the claims of Francis and Ke (2002), the results for small positive earnings surprises are robust regardless of whether the comparison group is all other earnings surprises or small negative earnings surprises. Our final set of results provide evidence of a significant negative association between non-audit fees and share values on the date the fees were disclosed, although the effect is small in economic terms.

auditor independence, auditor fees, earnings management, discretionary accruals

Abstract:
Building on the Dechow, Kothari, and Watts (1998) model of the accrual process, this study investigates the role of accruals in predicting future cash flows. The model shows that each accrual component reflects different information relating to future cash flows; aggregate earnings masks this information. As predicted, disaggregating accruals into major components - change in accounts receivable, change in accounts payable, change in inventory, depreciation, amortization, and other accruals - significantly enhances predictive ability. Each accrual component, including depreciation and amortization, is significant with the predicted sign in predicting future cash flows, incremental to current cash flow. The cash flow and accrual components of current earnings have substantially more predictive ability for future cash flows than several lags of aggregate earnings. The inferences are robust to alternative specifications, including controlling for operating cash cycle and industry membership.

Key Words: Accruals, Cash flow, Earnings, Cash flow prediction

Abstract:
We compare the predictive abilities of earnings and cash flows for future cash flows. We base our predictions on a model of the relation between future cash flows and past earnings and its components, including cash flows. As predicted, we find that current and past earnings explain significantly more variation in future cash flows than current and past cash flows, but only after permitting the cash and accrual components of earnings to have different multiples. As predicted, disaggregating the accrual component of earnings significantly further enhances the predictive ability of earnings for future cash flows. Contrary to claims in the popular press, the depreciation and amortization components of earnings have significant predictive ability for future cash flows. Our inferences are robust to controlling for operating cycle and industry membership.

Abstract:
We show that the asymmetric effects of income taxes and special items for profit and loss firms contribute substantially to a discontinuity at zero in the distribution of earnings. Income taxes draw profit observations towards zero while negative special items pull loss observations away from zero. These earnings components are thus expected to contribute to a discontinuity even in the absence of discretion. We show our results are not an artifact of deflation, and that other common components of earnings do not have similar effects on the earnings distribution around zero.

earnings management, earnings distributions, conservatism, taxes

Abstract:
This Essay examines the stock market's reaction to the Ninth Circuit's decision in re Silicon Graphics Securities Litigation. That decision adopted the most stringent interpretation of the Private Securities Litigation Reform Act's "strong inference" standard for pleading scienter in securities fraud cases. Studying the abnormal stock returns of a sample of high technology companies, the authors find a statistically significant positive return for shareholders of these companies to the Silicon Graphics decision. They also find that these positive stock price effects were strongest for those firms most likely to be sued in securities fraud class actions, but the results were less positive for those firms most likely to be sued for committing fraud. The authors conclude that the Silicon Graphics decision enhanced shareholder wealth on average. They argue that when the Supreme Court is called upon to interpret the Reform Act's pleading standard that it should adopt the Silicon Graphics standard.

Abstract:
This paper examines whether property-casualty insurance companies manage earnings to influence investor expectations at the time of equity issuances. Our tests focus on the discretionary component of a material accounting accrual recognized by property-casualty insurance companies, i.e., the reserve for policy claim losses. Required disclosures of revisions to loss reserve estimates allow us to develop a potentially more reliable measure of discretion than that used in prior research, and to examine firms' discretionary behavior for several years prior to initial public offerings. Based on a sample of 80 initial public offerings and 116 seasoned equity offerings between 1985 and 1997, we do not find evidence to support the hypothesis that managers opportunistically manage accruals prior to equity offerings. Because we do find evidence of earnings management in our sample, particularly by financially weak firms, our failure to document incremental earnings management prior to equity offerings is unlikely to be attributable to a lack of power. Our results are inconsistent with prior research, however, and raise the question of whether the results of other studies are due to discretion over accruals or to the decision to issue equity being correlated with factors (such as a peak in sales and earnings growth) that cause firms' accruals to appear extreme.

Abstract:
We document that firms reporting small positive earnings significantly understate the loss reserve accrual. Our findings also indicate that earnings management is not concentrated in these firms, but is pervasive across the entire earnings distribution. Consistent with income smoothing, the firms in the left tail of the earnings distribution understate reserve accruals while those in the right tail overstate reserve accruals. The results are similar for both stock and mutual insurers. We also show that both financially healthy and distressed firms manage earnings to avoid losses, and that both types of firms contribute to an overall appearance of income smoothing and opportunistic regulatory reporting.

Earnings management, losses, discretionary accruals, property-casualty insurance

Abstract:
Congress passed the Private Securities Litigation Reform Act of 1995 in an attempt to discourage meritless securities fraud class actions. This paper uses damages, accounting, insider trading and governance variables to explain the incidence of securities fraud litigation both before and after the passage of the PSLRA. Using a matched sample of sued and non-sued firms from the computer hardware and software industries, we find that our accounting and insider trading variables, which do not correlate with the incidence of litigation prior to the passage of the PSLRA, are significant after the passage of the PSLRA. This finding is confirmed by our analysis of allegations and outcomes. Our accounting variables do not explain the incidence of pre-PSLRA accounting allegations, but they become significant after the passage of the PSLRA. Similarly, insider trading variables do not explain insider trading allegations before the PSLRA, but net sales by insiders correlate with such allegations after its enactment. Finally, we find no correlation between lawsuit outcomes and our accounting variables before the PSLRA, but accounting variables are significant after its enactment. Abnormal insider sales correlate with outcomes before the PSLRA, but not after. Overall, we interpret our findings as evidence that the PSLRA has furthered Congress's goal of discouraging frivolous securities fraud lawsuits.

Securities litigation, litigation risk, accounting fraud, insider trading

Abstract:
This paper investigates the reaction of stock prices to enactment of the Private Securities Litigation Reform Act of 1995 (PSLRA). Based on a sample of 489 high-technology firms, we find that the PSLRA was wealth-increasing, on average, and that the market reaction was more positive for firms at greatest risk of being sued in a securities class action. However, we also show that the PSLRA was less beneficial for firms likely to be the subject of a meritorious lawsuit. Collectively, our evidence implies that shareholders generally benefit from restrictions on private securities litigation, although these benefits are mitigated when other mechanisms for curbing fraudulent activity are inadequate.

Abstract:
This paper investigates the reaction of stock prices to enactment of the Private Securities Litigation Reform Act of 1995 (PSLRA). Based on a sample of 489 high-technology firms, we find that the PSLRA was wealth-increasing, on average, and that the market reaction was more positive for firms at greatest risk of being sued in a securities class action. However, we also show that the PSLRA was less beneficial for firms likely to be the subject of a meritorious lawsuit. Collectively, our evidence implies that shareholders generally benefit from restrictions on private securities litigation, although these benefits are mitigated when other mechanisms for curbing fraudulent activity are inadequate.

Abstract:
This study evaluates corporate voluntary disclosure of forward-looking information under the safe harbor provision of the Private Securities Litigation Reform Act of 1995. Based on an analysis of earnings and sales forecasts issued by 523 computer hardware, computer software, and pharmaceutical firms, and controlling for other factors that may affect the disclosure decision, we find a significant increase in both the frequency of firms issuing forecasts and the mean number of forecasts issued following the Act's passage. To provide more direct evidence that our findings are attributable to the Act reducing firms' legal exposure, we develop a proxy for litigation risk and examine whether the increase in disclosure is more pronounced for firms at greatest risk of a lawsuit. As expected, we find that the change in disclosure is increasing in firms' ex ante risk of litigation. Finally, we report that the safe harbor had no adverse impact on the quality of forward-looking information released by management, contrary to claims made by opponents of the Act. In particular, our results indicate that forecast errors, whether directional or non-directional, were not significantly affected by the Act's passage.

Abstract:
This study evaluates corporate voluntary disclosure of forward-looking information under the safe harbor provision of the Private Securities Litigation Reform Act of 1995. Using data on earnings and sales forecasts issued by 547 computer, software, and drug firms, we find that there was a significant increase in both the frequency of firms issuing forecasts and the number of forecasts issued following enactment of the Reform Act. The increased level of disclosure is primarily attributable to managers issuing more long horizon forecasts of good news and short horizon forecasts of bad news. Moreover, there is some evidence that the forecasts issued after the safe harbor took effect specified a more precise estimate of expected future earnings performance. We also find that the increase in disclosure was not at the expense of forecast quality in that forecasts issued after passage of the Reform Act are no less accurate than those issued previously. In particular, there is no evidence to support critics' concern that the protection of the safe harbor would prompt managers to issue more overly optimistic statements to investors.

Abstract:
This study provides evidence that property-casualty insurers use accounting discretion to report a loss reserve accrual that captures relevant economic characteristics of the reserve's underlying cash flows. Specifically, tests of the relation between reported loss reserves and an actuarial estimate of expected future claim payments indicate that insurers discount loss reserves to present value even though industry accounting standards require recognition at nominal value. Additional findings indicate that the nondiscretionary (nominal value) and discretionary (time value discount) components of the loss reserve accrual are significantly associated with an external benchmark, insurance premiums, that reflects the present value of anticipated policy cash flows.

Abstract:
This study examines whether the reported loss reserves of property-casualty insurers contain an implicit discount for the time value of money. Reporting the present value of loss reserves enables insurers to justify the competitive level of insurance premiums to regulators. The evidence indicates that there is a positive and significant discount rate implicit in the relation between reported loss reserves and expected future claim payments. Moreover, insurers subject to relatively stringent rate regulation discount to a greater extent than other insurers. The results also suggest that implicit discounting is distinct from solvency and tax motives to exercise discretion over the loss reserve.

Abstract:
This study examines whether the reported loss reserves of property-casualty insurers contain an implicit discount for the time value of money. Reporting the present value of loss reserves enables insurers to justify the competitive level of insurance premiums to regulators. The evidence indicates that there is a positive and significant discount rate implicit in the relation between reported loss reserves and expected future claim payments. Moreover, insurers subject to relatively stringent rate regulation discount to a greater extent than other insurers. The results also suggest that implicit discounting is distinct from solvency and tax motives to exercise discretion over the loss reserve.

Abstract:
This study investigates firms' voluntary disclosure of cautionary language under the safe harbor of the Private Securities Litigation Reform Act of 1995. We examine three disclosure attributes indicative of meaningful cautionary language under the statute. Consistent with predictions, we find that firms subject to greater litigation risk disclose more cautionary language, update the disclosure more from year-to-year, and use more readable language. The response to changes in litigation risk is asymmetric; firms increase their use of cautionary language when litigation risk increases but do not remove cautionary language when litigation risk decreases. Taken together, our evidence suggests that firms adopt disclosure policies to reduce the expected costs of litigation.

Voluntary disclosure, litigation risk, safe harbor, forward-looking information

Abstract:
This paper examines the effect of the Private Securities Litigation Reform Act of 1995 (PSLRA) on stockholder lawsuits. We explore the role of restatements, earnings forecasts, and insider trading in the filing and resolution of lawsuits for a sample of high technology firms. Consistent with our predictions, there is a post-PSLRA shift away from litigation based on forward-looking earnings disclosures. Conversely, there is a significantly greater correlation between litigation and both earnings restatements and abnormal insider selling after the PSLRA. Finally, we find a post-PSLRA increase in the likelihood of settlement for cases involving earnings restatements.

securities litigation, litigation risk, accounting fraud, insider trading

Abstract:
Prior research shows that the PSLRA increased the significance of merit-related factors, such as the presence of an accounting restatement or insider selling, in determining the incidence and outcomes of securities fraud class actions. (Johnson, Nelson, and Pritchard, 2007). This result, however, is consistent with two possible hypotheses. First, the PSLRA may have reduced solely the incidence of non-meritorious litigation. Second, the PSLRA may have changed the definition of merit, effectively precluding claims that would have survived and produced a settlement pre-PSLRA. This paper tests these alternative hypotheses. We find that pre-PSLRA claims that settled for nuisance value would be less likely to be filed under the PSLRA regime. We also find, however, that pre-PSLRA non-nuisance claims would be less likely to be filed post-PSLRA period. The latter result, which we refer to as the screening effect, is particularly pronounced for claims lacking obvious hard evidence indicia of fraud (an accounting restatement or an SEC investigation). This screening effect is stronger if the claims also lacked evidence of abnormal insider trading. By contrast, we find that pre-PSLRA claims with hard evidence or abnormal insider trading would be no less likely to be filed in the post-PSLRA period. We also examine the likelihood of settlement for pre-PSRLA claims if they had been filed in the post-PSLRA period, and find a similar screening effect for case outcomes. We conclude that Congress effectively changed the definition of merit in adopting the PSLRA, discouraging suits that would have produced a non-nuisance outcome prior to the law's enactment.

Stockholder litigation, accounting restatements, earnings forecasts, insider trading

Abstract:
This paper tests the hypothesis that negative client stock returns following the revelation that Enron documents had been shredded are attributable to confounding effects as opposed to a loss of Andersen's reputation. We find that a sharp decline in oil prices along with a disproportionate share of energy clients combine to produce significantly more negative returns for Andersen clients relative to other Big 4 clients, and for Andersen's Houston office clients relative to its clients in other locations. Further, the returns of Andersen clients are no different from those experienced by Big 4 clients in nine out of ten industry sectors. Additional tests of earnings response coefficients reveal no change in the market's valuation of clients' earnings after the shredding announcement. Overall, we conclude the market reaction surrounding the shredding date is attributable to market-wide news events rather than the loss of Andersen's reputation.

Auditor reputation, Arthur Andersen, Event studies, Earnings response coefficients

Abstract:
For some time, a debate has existed on the relevance of fair value versus historical cost for the valuation of financial instruments. In this study, we conduct three experiments to test the idea that investors’ views about fair value are contingent (that is, investors are not either “fair value” or “historical cost” supporters), depending on whether the item in question is an asset or liability and the situation being evaluated. Results are supportive of our predictions and also indicate that investors use a non-diagnostic “ease of acquiring or selling” heuristic to judge the relevance of fair value. Our results also reveal that attempts to debias investors’ judgments by providing them with the economic intuition does work, although it may lead to unintended effects. Implications for standard setters and investors are provided.

fair value, relevance, judgment bias

Abstract:
This paper examines the effect of the Private Securities Litigation Reform Act of 1995 (PSLRA) on stockholder lawsuits. We explore the role of restatements, earnings forecasts, and insider trading in the filing and resolution of lawsuits for a sample of high technology firms. Consistent with expectations, there is a post-PSLRA shift away from litigation based on forward-looking earnings disclosures. Conversely, there is a significantly greater correlation between litigation and both earnings restatements and insider selling after the PSLRA. There is no evidence, however, of an association between litigation and abnormal insider selling either before or after the PSLRA, even though this measure conforms more closely with legal standards for assessing fraudulent intent. Finally, we find a post-PSLRA increase in the likelihood of settlement for cases involving earnings restatements and abnormal insider selling. Thus, unlike lawsuit filings, the outcome of litigation does conform with judicial doctrine regarding insider trading. Consistent with Skinner (1997), there is no association between the likelihood of settlement and firms' forward-looking earnings disclosures.

stockholder litigation, restatements, earnings forecasts, insider trading

Abstract:
This study examines the role of attention in the context of the market response to spam messages and in the selection of targeted stocks. Compared to prior research on larger, more widely-traded stocks, this setting offers a unique opportunity to explore attention-driven investment decisions using a sample of firms essentially unknown prior to the attention event. We show that returns and abnormal volume are highest in the subset of stocks targeted by spam emails that catch investors' attention with extreme target prices and stale press release information. Attention effects also contribute to spammers' selection of stocks to target. Spammed stocks are significantly more likely to have an unusual level of recent trading volume and news. Overall, the findings complement and extend the growing literature on factors influencing investor attention and its effect on asset prices.

Investor attention, Spam, Target prices, Press releases

Abstract:
This paper tests the hypothesis that negative client stock returns following the revelation that Enron documents had been shredded are attributable to confounding effects as opposed to a loss of Andersen's reputation. We find that a sharp decline in oil prices along with differences in the industry composition of the Andersen and Big 4 client portfolios combine to produce significantly more negative returns for Andersen clients relative to Big 4 clients, and for Andersen's Houston office clients relative to its clients in other locations. The market reaction to two other Enron-related events also offers little support for a reputation effect.

Auditor reputation, Arthur Andersen, Event studies, Earnings response coefficients

Abstract:
This article examines the effect of the Private Securities Litigation Reform Act of 1995 (PSLRA) on stockholder lawsuits. We explore the role of restatements, earnings forecasts, and insider trading in the filing and resolution of lawsuits for a sample of high technology firms. Consistent with our predictions, there is a post-PSLRA shift away from litigation based on forward-looking earnings disclosures. Conversely, there is a significantly greater correlation between litigation and both earnings restatements and abnormal insider selling after the PSLRA. Finally, we find a post-PSLRA increase in the likelihood of settlement for cases involving earnings restatements.

Abstract:
Using a comprehensive sample of switches to and from the largest auditors (i.e., the Big N), we examine empirically whether the sensitivity of Big N auditor switches to client risk and misalignment changed between the pre- and post-Enron periods. Although we find an increase in the sensitivity to client misalignment, the sensitivity to client risk generally decreases. The results are consistent with Big N auditors rebalancing their audit client portfolios in response to post-Enron capacity constraints arising from the supply of former Arthur Andersen clients and the audit demands imposed by Sarbanes-Oxley rather than increasing their sensitivity to client risk. Additional evidence indicates that the Sarbanes-Oxley demand shock did not affect Big N auditor switching behavior incremental to the initial Andersen supply shock.

Auditor change, audit risk, audit firm portfolios