Contributions published at Financial Accounting (Hui Chen)

We investigate how interdependence among investors' beliefs affects the reliance on market prices as a performance measure and how this in turn affects the firm's preference for financial reporting quality. When investors want to align their values more with other investors' beliefs, optimal contracts become more reliant on the accounting report and less on the market price, emphasizing the stewardship role of accounting in a herding market. If the baseline accounting quality required by a reporting standard is high enough, the firm prefers to increase its accounting quality for the sake of contracting efficiency. However, if the baseline quality is low, the firm further lowers accounting quality for the same reason. The benchmark level that determines whether the firm prefers to increase accounting quality increases with the interdependence of investors' beliefs, implying that it is difficult to align the information and stewardship roles of accounting in a herding market.

We study a publicly traded firm that cares about its stock market performance, while collaborating with a privately owned firm in a business alliance. The firms each undertake a relation-specific investment and then bargain over the allocation of the joint surplus generated by the alliance. The public firm's market concerns affect both the total size of the surplus and how the surplus is divided by the firms. While the public firm always becomes more aggressive and obtains a higher portion of the surplus, the total size of the surplus may become larger or smaller due to the effect of market concerns on the firms' investment incentives. We establish conditions under which the investment and the value of each firm increase or decrease with market concerns. The market concerns could mitigate or exacerbate the hold-up problem between the two firms and thus could be either beneficial or detrimental for the whole business alliance. We also study two extensions with (i) the two investments being substitutes instead of complements, and (ii) both firms being publicly listed. In both cases, the insights from our main model still hold true.

We study voluntary disclosure strategies in leader-follower games where firms choose real actions sequentially after simultaneously disclosing information. We show that the leader incurs an endogenous consistency cost when withholding information because it must choose a suboptimal real action to avoid that its private information is revealed to the follower. This consistency cost induces the leader to disclose more information in equilibrium than an equally informed follower. We establish this result in the context of a voluntary disclosure model with uncertain information endowment and show that it is robust under alternative modeling choices regarding the disclosure friction, the number of followers, and the impact of firms' private information on their rivals' profit.

We examine the evolution of accounting regulation by linking disclosure policies and investments in a dynamic voting model, where the disclosure requirement is the outcome of voting. Firms’ preferences over disclosure policies are determined by their investments, which are in turn decided by current and future disclosure policies. Absent external influences, accounting regimes are stable. A disclosure regime of high (low) quality and a strong (weak) economy coexist and reinforce each other. However, regulatory interventions can result in regime changes by changing the entrepreneurs’ expectations, even without direct enforcement. Unexpected shocks could also result in regime changes by impacting economic conditions and hence voter composition. Our analysis provides a framework to study the interaction between accounting regulation and firms’ economic decisions.

We consider a setting where managers manipulate the firms’ real activities in anticipation of insider trading opportunities. Managers choose strictly higher production quantities than the quantities chosen absent insider trading, implying lower firm profit but higher consumer surplus. Through comparative statics, we show the overproduction is mitigated by the degree of competition in the industry, the manager’s current equity stake in the firm, and the precision of cost information. We also analyze the effects of insider trading in several extensions including asymmetric ownership structure, potential horizontal merger, and common market maker.

We regard accounting regulation as a politico-economic institution and analyze its evolution in the presence of changing investor sentiment. When the market sentiment is moderate, if most of the business projects in the economy are successful, the economy will enter a stable high-disclosure regime. If most of the projects are unsuccessful, the economy may enter a stable low-disclosure regime or experience a regime change from low to high disclosure. The regime change can take place if the economy coordinates on a future high disclosure quality, which will induce a Pareto improvement and is thus supported by all interest groups in the economy. In contrast, when the market sentiment is extremely hyped up, low disclosure regime will always emerge. While an initial majority of unsuccessful projects will lead the economy into a stable low-disclosure regime, an initial majority of successful projects will also result in a low disclosure regime. This regime change from high to low disclosure occurs because even successful projects benefit from low disclosure due to the significant price boost. These results are generally consistent with the observed development of accounting regulation.

A significant portion of CEOs in publicly-listed Chinese state-owned enterprises receive zero pay from the companies for which they work. Instead, they are paid directly by their controlling shareholder who can be the Chinese government or parent firms controlled by the Chinese government. While their actual pay is unobservable, it is known to be low and contain few performance-based incentives. We explore how these parent-paid executives are motivated and whether the outcomes of this unusual incentive differ from conventional compensation. Consistent with career concerns as their main incentive, we find that these CEOs have a significantly higher probability of future promotion than other CEOs. We also conduct an event study using the Split Share Structure Reform in 2005. The reform liberalized the Chinese stock market and enhanced the role of the market mechanisms that potentially replaced promotion incentives in executive compensation contracts. Our evidence is generally consistent with a reduction in the strength of promotion incentives following the reform. Further analyses indicate that, compared to peers that directly pay their CEOs, firms with parent-paid CEOs have higher return on assets and asset growth, and they experience less tunneling by their shareholders.

We analyze the effect of accounting bias on the competition and market structure of an industry. In our model, firms’ interim accounting reports on investment projectsmay contain bias introduced by the mandatory accounting system. We find that this biasstrictly decreases firms’ profits when investors do not have an abandonment option, butdifferent results emerge when we allow the investors to divest in the interim. Specifically,a conservative accounting regime may increase the likelihood of projects being discontin-ued, inducing some firms to exit from the product market and leaving rivals to capturetheir market share. A conservative regime can thus soften market competition and resultin ex ante higher investment payoff, higher consumer surplus, and higher total socialwelfare. Since industries often have common reporting standards, we also identify thedegrees of industry-wide accounting bias that maximize the expected investor payoffs.Finally, we allow for investors to coordinate their divestment decisions when both firmsreport unfavorable costs and show an improvement to both firm profits and consumer surplus.

Regulators and the public have expressed concerns about accounting firms lobbying politicians and regulators on behalf of their own audit clients because it could pose an advocacy threat to auditor independence. In this study, we examine whether these lobbying activities by accounting firms are associated with their clients’ audit quality. As required disclosures of lobbying activities under the Lobbying Disclosure Act are very limited, we construct aproxy to capture auditor lobbying on behalf of audit clients. Using our proxy for lobbying, we find that perceived audit quality (measured using earnings response coefficients) is negatively related to lobbying. However, we fail to find that actual audit quality is lower for these clients (measured as the propensity to restate earnings, propensity to issue a going-concern opinion, and discretionary accruals). Our findings suggest that investors perceive auditors’ lobbying for clients’ political interests as harmful to audit quality but that these concerns do not appear to materialize in the financial statements. Similar to the literature on other nonaudit services, our evidence suggests that reputation concerns and litigation risk provide enough incentive for auditors to maintain their independence in the presence of an advocacy threat to auditor independence.

A significant portion of CEOs in publicly-listed Chinese state-owned enterprises receive zero pay from the companies for which they work. Instead, they are paid directly by their controlling shareholder, which can be the Chinese government or parent firms that are controlled by the Chinese government. We explore how these “unpaid” executives are motivated and whether the outcomes of this unusual incentive mechanism differ from the conventional approach. Consistent with career concerns as their main incentive mechanism, we find that these CEOs have a significantly higher probability of future promotion than other CEOs. This result holds when we look at subsamples in which individual CEOs switch payment regimes. We also find that compared to their peers with paid CEOs, firms with unpaid CEOs in general have higher return on assets, higher asset turnover, higher asset growth, and engage in less tunneling. To mitigate concerns of that our results are driven by CEO selection and to further investigate the use of implicit incentives, we conduct an event study using the Split Share Structure Reform in 2006. The Reform liberalized the Chinese stock market, thus strengthening the role of the market as an incentive mechanism. This mechanism provides a potential replacement for promotion incentives. Our evidence is generally consistent with a reduction in the strength of promotion incentives following the reform.

Corporate insiders, particularly managers, not only have access to their firms' private information, but also control over their firms' operational decisions. In this paper, we consider a setting where managers manipulate the firms' real activities in anticipation of subsequent insider trading opportunities. We find these managers choose production quantities that are strictly higher than the quantities absent insider trading. The overproduction leads to lower firm profits but higher consumer surplus. When we allow the managers to trade both in their own firms' and their rival firms' stocks, we find that the competition among insiders in the financial market drives down the expected insider trading profits and their incentives to distort production decisions. We then discuss the scenario of "substitute trading" when the managers only trade in their rival firms' shares, and show that the managers can earn some insider benefits without sacrificing their firms' profitability. We also explore the possibility of endogenizing the managers' ownership through compensation contracts.

The purpose of this paper is to investigate the impact on pay-performance sensitivity of the Sarbanes–Oxley Act (SOX), an effect that has been examined in prior research but with often conflicting findings. Using a more comprehensive sample of executives and of compensation components than in prior research, we compare managers’ pay-performance sensitivity before and after 2001-2002, a period during which regulatory changes were initiated to increase scrutiny over managerial manipulation and improve financial reporting quality. Based on ExecuComp data from 1992 to 2005 (and excluding the years 2001 and 2002), our results show that pay-performance sensitivity using either market-based or accounting-based measures of performance increased significantly following these events. When we further decompose executive pay into its cash-based and equity-based components, we find evidence of an increase in the link between performance and executive compensation for five of six measures for each performance metric. Thus, in contrast to most prior studies on the impact of SOX on executive incentives and compensation, our evidence is consistent with an improvement rather than weakening in the alignment of managerial and shareholder interests.

Corporate lobbying activities are designed to influence legislators, regulators and courts, presumably to encourage favorable policies and/or outcomes. In dollar terms, corporate lobbying expenditures are typically one or even two orders of magnitude larger than spending by Political Action Committees (PAC), and, unlike PAC donations, lobbying amounts are direct corporate expenditures. We use data made available by the Lobbying Disclosure Act of 1995 to examine this more pervasive form of corporate political activity. We find that, on average, lobbying is positively related to accounting and market measures of financial performance. These results are robust across a number of empirical specifications. We also report market performance evidence using a portfolio approach. We find that portfolios of firms with the highest lobbying intensities significantly outperform their benchmarks in the three years following portfolio formation.

In this paper, we examine a firm’s choice of operating leverage in a principal-agent setting and find that the degree of operating leverage is strictly lower when the manager’s actions are unobservable. Further, the production output is also lower when agency problems are present. The suboptimal operational decisions result in not only decreased shareholder value, but also lower consumer surplus and lower total social welfare. However, accounting information can help mitigate this problem. Specifically, the more precise the accounting information, the less the reduction in the players’ payoffs. The results of this paper may provide some insight on how risk affects a firm’s stakeholders differently, and what consequences it has in a broader economic sense.

In this paper, we examine a firm's choice of operating leverage in a principal-agent setting and find that the degree of operating leverage is strictly lower when the manager's actions are unobservable. Further, the production output is also lower when agency problems are present. The suboptimal operational decisions result in not only decreased shareholder value, but also lower consumer surplus and lower total social welfare. However, accounting information can help mitigate this problem. Specifically, the more precise the accounting information, the less the reduction in the players' payoffs. The results of this paper may provide some insight on how risk affects a firm's stakeholders differently, and what consequences it has in a broader economic sense.

Prior literature raises a “puzzle” of high rates of return on corporate political investment, but evidence for this puzzle is largely descriptive in nature. We exploit the setting of the American Jobs Creation Act’s passage in 2004 to provide more robust estimates of political returns based on instrumentation in a two-stage regression model. We find for the median sample firm that an increase of $1 million in lobbying spending is associated with about $32.35 million in taxes saved. These estimates, while consistent with a high-returns “puzzle,” are nearly an order of magnitude lower than those previously reported via descriptive methods.

Regulators and the public are concerned about accounting firms lobbying politicians on behalf of their own audit clients because it could impair auditor independence. In this study, we examine whether these lobbying activities by accounting firms are associated with their clients’ audit quality. Since required disclosures of lobbying activities are limited, we construct a novel proxy to capture auditor lobbying on behalf of audit clients. Using this proxy, we find that perceived audit quality is negatively related to lobbying. However, we fail to find that actual audit quality is lower for these clients. Our findings suggest that investors perceive auditors’ lobbying for clients’ political interests as harmful to audit quality but that these concerns do not appear to materialize in the outcome of the audit process. This evidence suggests that reputation concerns and litigation risk may provide enough discipline for auditors to maintain independence.

Corporate lobbying activities are designed to influence legislators, regulators, and courts, presumably to encourage favorable policies and/or outcomes. In dollar terms, corporate lobbying expenditures are typically one or even two orders of magnitude larger than spending by Political Action Committees (PAC), and unlike PAC donations, lobbying amounts are direct corporate expenditures. We use data made available by the Lobbying Disclosure Act of 1995, to examine this more pervasive form of corporate political activity. We find that on average, lobbying is positively related to accounting and market measures of financial performance. These results are robust across a number of empirical specifications. We also report market performance evidence using a portfolio approach. We find that portfolios of firms with the highest lobbying intensities significantly outperform their benchmarks in the three years following portfolio formation.