Research Main Page


(click to read abstracts and for links to papers)

Earnings Management and the Strategic Role of Disclosure


Idea: Firms respond to uncertainty by decreasing real activities decisions and increasing voluntary disclosure.

Abstract: We examine the effect of political uncertainty on corporate transparency and market quality using gubernatorial elections as a source of plausibly exogenous variation in uncertainty. Despite real activity falling in the years leading up to a close election, voluntary disclosure, measured by the frequency and content of voluntary 8-K filings and managerial guidance, increases. These effects are stronger before elections in which the incumbent has termed out or with recent party flipping, and reverse after the election. We find that political uncertainty increases trading costs and reduces analyst information production, which firms mitigate by increasing transparency.

Link to paper       (election data)

 

Idea: The Federal Reserve exhibits a stance that varies across banks and time; this stance (propping up or disciplining) matters for subsequent bank behavior.

Abstract: We investigate bias in the Federal Reserve's stress test disclosures for the Comprehensive Capital Analysis and Reviews (CCAR) between 2012 and 2017. Using the market response to the report, we develop and implement a model of biased disclosure that incorporates a regulator's trade-off between market discipline and short-term stability. We find that disclosed capital ratios are biased upwards to prop up systemically important banks, but downwards to discipline poorly capitalized banks. This bias has real consequences for bank behavior -- propped-up banks are less likely to subsequently improve their capital ratios, either by increasing equity or reducing risk-weighted assets.

Link to paper

 

Idea: We provide evidence for the channel through which well-governed financial markets spur on economic development.

Abstract: By allowing investors to efficiently allocate capital, developed financial markets promote economic growth. We revisit a key component of financial market development, namely financial reporting standards, to identify a channel underpinning this link. We focus on introductions of new financial reporting standards and construct a novel text-based, firm-level measure of sensitivity to these standards. Relative to insensitive firms, sensitive firms reduce securities issuance by 11.4% and, despite compensating with internal sources of funds, cut investment by 10.8% after standards. These findings demonstrate that new standards trigger a substantial reallocation of capital through financial markets.

Link to paper

 

Idea: Lenders manage earnings to meet short term benchmarks by enforcing contractual breaches by borrowers at a higher rate. This has negative impacts on borrowers.

Abstract: To meet short-term benchmarks, lenders may alter their monitoring behavior, providing a channel for short-termism incentives to spill over into the corporate sector. We find that lenders with short-termism incentives enforce material covenant violations at higher rates. Further, they target relatively higher quality borrowers with which they have a prior relationship and that are less financially constrained. Affected borrowers switch lenders more frequently, receive worse loan terms on future loans, and reduce investment. Market reactions to announcements of material covenant violations when lenders have short-term incentives are 0.88% lower, suggesting that short-termism spillovers are value-decreasing for borrowers.

Link to paper

 

Idea: Level-the-playing-field policies that make internal information more available to market participants can crowd out information gathering by markets that is important to efficient managerial decisions.

Abstract: We study whether and how publicizing internal information affects the value of financial markets to the real economy. By publicizing corporate filings, the SEC's EDGAR web platform reduces the cost of acquiring internal information for outsiders and so makes it relatively less attractive to gather external information. We find that the staggered introduction of EDGAR reduced the sensitivity of firm investment to prices, consistent with prices being less informative to managers due to the crowding out of external information gathering. This crowding out effect is stronger when outsiders' incentives for gathering information are stronger and for firms that rely more on external information. Our findings suggest that policies designed to “level the playing field” by publicizing internal information can have significant unintended consequences by reducing the informativeness of prices for real decisions.

Link to paper

 

Idea: To uncover the costs of earnings management, we empirically link evidence of manipulation in the earnings surprise distribution to the fact that positive earnings surprises receive positive abnormal returns.

Abstract: Two well-known stylized facts on earnings management are that the earnings surprise distribution has a discontinuity at zero, and that positive earnings surprises are associated with positive abnormal returns. We link these two facts in a model of the earnings management decision in which the manager trades off the capital market benefits of meeting earnings benchmarks against the costs of manipulation. We develop a new structural methodology to estimate the model and uncover the unobserved cost function. The estimated model parameters yield the percentage of manipulating firms, magnitude of manipulation, noise in manipulation, and sufficient statistics to evaluate proxies for identifying firms suspected of manipulation. Finally, we use the Sarbanes--Oxley Act as a policy experiment and find that by increasing costs, the Act reduced equilibrium earnings management by 36%. This reduction occurred despite an increase in benefits, consistent with the market rationally becoming less skeptical of firms that just meet benchmarks.

Link to paper

 

Idea: Banks hold an informational advantage to the market with respect to their borrowers. A borrower can limit informational hold up by disclosing key financial metrics in its loan agreements.

Abstract: To mitigate holdup by an informed incumbent lender, a private borrower may publicly share information in order to increase lender competition. Despite proprietary costs, a subset of private borrowers voluntarily share private information in loan and credit underwriting agreements. These borrowers switch lenders at a 16% higher rate and receive lower loan financing costs. For private firms that go public, we analyze changes in the net benefits of information sharing and study the potential estimation bias from unobservable borrower quality. This setting corroborates our inference that voluntary information sharing reduces lender holdup and alleviates financial constraints for private firms.

Link to paper

 

Idea: If a firm lowers its tax expense, its peers respond by lowering their tax expense, but appear to do so only for reporting purposes.

Abstract: A growing literature examines how a firms behavior impacts the behavior of its peers. In this paper, we examine how changes in tax paying, and the associated financial reporting, impact a firm's peers. Changes to tax paying and reporting behavior at other firms within a peer group can be affected by many of the same factors, such as industry-level tax policy changes or audit risk, so we make use of exogenous-to the peer firms-shocks to tax behavior. Following the methodology of Dyreng, Hanlon, and Maydew [2010], we estimate managerial tax avoidance fixed effects and use these to identify tax rate shocks associated with executive turnover. We find that peer firms respond to these shocks by changing their GAAP tax rates in the same direction. The magnitude of the effect corresponds to an approximately 10% response to the average change in peer group GAAP effective tax rates. Our evidence suggests that these peer effects occur only for book, rather than cash, effective tax rates. This finding of a differential response in financial reporting compared to tax payments is consistent with the primacy of earnings-based measures to managers and other capital market participants.

Link to paper

 


Financial Intermediaries and Institutions


Idea: We provide archival evidence that suppliers have private information about their customers.

Abstract: Theories of customer-supplier relationships propose that the private information that suppliers have about buyers explains why trade credit arises in the presence of a competitive banking sector. However, there is limited evidence that trade creditors possess private information about the quality of buyers. Using a novel dataset of trade credit relationships, we find evidence consistent with suppliers possessing private information about buyers. The amount of trade credit that a supplier offers to a buyer and the ability of the buyer to pay back the trade credit on time are both positively associated with future buyer financial performance and solvency. Finally, increases in trade credit and the timeliness of payments are also associated with higher returns surrounding subsequent earnings announcements and lower volatility.

Link to paper

 

Idea: Banks forbear on their borrower's contractual breaches, only enforcing these contracts 11% of the time.

Abstract: We use a regression discontinuity design to study ex-post discretion in lender's contractual enforcement of restrictive covenant violations. At pre-set thresholds, we find that lenders enforce contractual breaches at an 11% rate, varying between 5% and 18% and peaking when credit conditions are tightest, consistent with enforcement exacerbating credit cycles. Costly coordination reduces enforcement; increasing the number of lenders required to vote for enforcement action by one reduces the enforcement propensity by 6.3%. Enforcement is less frequent for borrowers with easy access to external financing and for well-reputed lead arrangers, suggesting that optimal enforcement depends on endogenous matching.

Link to paper

 

Idea: We find the first evidence of first impression bias in the field.

Abstract: We present evidence of first impression bias among finance professionals in the field. Equity analysts' forecasts, target prices, and recommendations suffer from first impression bias. If a firm performs particularly well (poorly) in the year before an analyst follows it, that analyst tends to issue optimistic (pessimistic) evaluations. Consistent with negativity bias, we find that negative first impressions have a stronger effect than positive ones. The market adjusts for analyst first impression bias with a lag. Finally, our findings contribute to the literature on experience effects. We show that a set of professionals in the field, equity analysts, apply U-shaped weights to their sequence of past experiences, with greater weight on first experiences and recent experiences than on intermediate ones.

Link to paper
Post on Harvard Law School Forum on Corporate Governance
Media mention by Matt Levine on Bloomberg

 


Market Microstructure


Idea: Short selling restrictions targeting speculative short selling do have a positive impact on returns, in contrast to findings in previous studies, something we are able to show using intermittent Rule 201 restrictions on active short order placement.

Abstract: Despite strong theoretical predictions based on disagreement, limited empirical evidence has linked short selling restrictions to higher prices. We test this relationship using quasi-experimental methods based on Rule 201, a threshold-based policy that restricts aggressive short selling when intraday returns cross -10%. When comparing stocks on either side of the threshold in the same hour of trading, we find that the restriction leads to 8% lower short sale volume and 35 bps higher daily returns. These price effects do not reverse and are not associated with information events, suggesting that Rule 201 restricts short selling based on transient opportunities unrelated to fundamentals. Although these persistent direct effects align with policymaker objectives, we find evidence of offsetting transient spillover effects on peer stocks consistent with cross-stock substitution by short sellers.

Link to paper

 

Idea: We develop a practical test of Kyle and Obizhaeva's (2016) bet invariance theory and find support for no speculative arbitrage within a period of time, but not over the course of the trading day.

Abstract: We derive testable implications of Kyle and Obizhaeva's (2016) notion of "bet invariance'' for the cross-section of trade-time volatilities. We jointly develop theoretical foundations of "no speculative arbitrage'' whose implications incorporate those of bet invariance. Our proposed test circumvents the unobservable nature of "bets.'' Utilizing a large sample of U.S. stocks post decimilization, we show that using realized volatilities rather than expected volatilities introduces noise that substantially biases the tests. This leads us to use estimates of normalized volatilities based on running 24 month windows. We find strong support for no speculative arbitrage at a moment in time, but not across time.

Link to paper

 

Idea: A simple correction to the numerator of the most commonly used stock liquidity measure produces liquidity premia coefficients double that of the original measure.

Abstract: Amihud's (2002) stock (il)liquidity measure averages daily ratios of absolute close-to-close return to dollar volume, including overnight returns, while trading volumes come from regular hours. Our modified measure addresses this mismatch by using open-to-close returns. It is more strongly correlated with standard trading-cost measures (by 8-37%) and it better explains cross-sections of returns, doubling estimated liquidity premia. Using non-synchronous trading near close as an instrument reveals that overnight returns are primarily information-driven and orthogonal to price impacts of trading: including them in liquidity proxies magnifies measurement error, understating liquidity premia. Our modification helps wherever use of Amihud's measure is required. Our measures are publicly available to researchers for the years 1964-2019, and can be updated in future years using CRSP and COMPUSTAT.

Link to paper       (Publicly available data for 1964-2020)