Research Main Page
(click to read abstracts and for links to papers)
Idea: Managers overinvest to facilitate misreporting and preserve investment flexibility by hoarding cash and underutilizing debt.
Abstract: A fundamental question is whether incentives to meet or beat earnings expectations impact corporate decisions. We develop a dynamic model of a manager making joint decisions over investment, financing, and accounting discretion. We estimate this model, identifying earnings management parameters considering the intertemporal tradeoffs managers face when addressing these choices. We find that firms overinvest to accommodate earnings management and underutilize debt, hoarding cash, to preserve flexibility when profitable opportunities arise. The corporate finance literature finds that individual firm investment and debt issuance exhibit coincident spikes in the data but has difficulty rationalizing this fact. We find that a model that allows for accounting discretion better fits these spikes in the data than a model that does not. Our paper answers the call in the literature for empirical models accounting for the tensions between accounting discretion and investment and financing decisions.
Idea: We find that markets underreact to large earnings per share numbers, consistent with number processing constraints in human brains.
Abstract: Neuroscience shows that human brains are neurologically constrained to process small numbers linearly and large numbers logarithmically, leading to underreactions to larger numbers as their perceived difference becomes smaller. We test this hypothesis in the context of earnings announcements (EAs) and find that investors respond less in the short term to earnings news for stocks with high EPS magnitudes, exacerbating post-earnings announcement drift for these stocks. These findings are distinct from and incremental to several risk-based and behavioral explanations, attenuated by robot presence, and present in a quasi-experimental design using stock splits. Our evidence suggests that number processing constraints have implications for stock price efficiency.
Idea: Decentralized enforcement can lead to inadequate oversight when misconduct crosses state lines.
Abstract: The Occupational Safety and Health Administration (OSHA) is decentralized, wherein field offices coordinated at the state level undertake inspections. We study whether this structure can lead to interstate frictions in sharing information and how this impacts firms’ compliance with workplace safety laws. We find that firms caught violating in one state subsequently violate less in that state but violate more in other states. Despite this pattern, and in keeping with information frictions, violations in one state do not trigger proactive OSHA inspections in other states. Moreover, firms face lower monetary penalties when subsequent violations occur across state lines, likely due to the lack of documentation necessary to assess severe penalties. Finally, firms are more likely to shift violating behavior into states with greater information frictions. Our findings suggest that internal information within regulators impacts the likelihood and location of corporate misconduct.
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.
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.
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.
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
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.
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.
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.
Idea: We show that low rewards in Proof-of-Stake (PoS), the predominant protocol among cryptocurrencies, can lead to coordinated exit by stakers, undermining value.
Abstract: Crypto-assets increasingly rely on the capital-intensive Proof-of-Stake protocol over the energy-intensive Proof-of-Work protocol to validate transactions. We model a population of investors who decide to stake, reaping staking rewards, or exit, liquidating their crypto-asset holdings. Runs on staking are more common when the crypto-asset's protocol is weaker, when price impacts of protocol failure are high, or when rewards to staking are low. We extend the model to leveraged staking, where margin calls exacerbate run dynamics. In examining staking lock-up periods, we find that a longer lock-up period can reduce failures but also leads to more frequent, if slower, runs and a decrease in the value of the crypto-asset. Previous work demonstrates that consensus and security of a crypto-asset depend on low staking rewards, but our results highlight that low rewards induce runs.
Idea: Do natural disasters impact local business activity? We find the answer is yes but not in the way one might think.
Abstract: This paper studies the impacts of natural disasters on economic activity at the local level using data on foot traffic to businesses. We find little evidence that natural disasters impact total foot traffic at the monthly time horizon. However, the share of foot traffic going to public companies increases post-disaster, at the expense of smaller, private businesses. This is especially true for the retail industry, where the link between foot traffic and sales is likely to be the strongest. Furthermore, the share of foot traffic going to private stores post-disaster falls disproportionately in less populous, high minority areas. Some public company business models specifically take advantage of this phenomenon. Dollar stores, which target areas with low population and high natural disaster risk, see a spike in foot traffic share in the disaster month that persists post-disaster. We additionally show that dollar store and retail stocks perform especially well post-disaster.
Idea: We provide evidence that there is value in disclosing privately held information about payment timeliness by buyers.
Abstract: Payment timeliness in trade credit transactions is a key metric suppliers use to monitor their buyers. However, firms are not required to disclose payment timeliness information. In theory, late payments could be either a positive or negative indicator of future performance. We find that late payment by buyers is negatively associated with future buyer financial performance and positively associated with subsequent default risk. This suggests that late payments are an indicator of inability to pay on time rather than an indicator that firms are delaying payments to fund profitable investments. The predictive power of payment timeliness for fundamentals is stronger for low liquidity and distressed firms. Finally, we find a significant association between payment timeliness and future stock returns, suggesting that investors do not fully incorporate payment timeliness information. Our evidence regarding the informativeness of payment timeliness is relevant for the ongoing regulatory debate on whether firms should disclose payment timeliness.
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.
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.
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)