Sandra Chamberlain

This thesis is a collection of two studies on the capital market consequences of financial reporting weaknesses. Chapter 2 examines the change in voluntary disclosure of internal control deficiencies (ICD) by IPO firms after the JOBS Act. The JOBS Act postponed the compliance deadline of internal control audits after IPO and increased the number of small IPO firms with potential ICD. I find that IPO firms are more likely to disclose ICD after the JOBS Act. Further, post-JOBS IPO firms who are willing to disclose ICD experience lower underpricing. These results are consistent with a dynamic view that as investors rationally update the belief of increasing “lemons” in the IPO population after the JOBS Act, IPO firms become more forthcoming with ICD disclosure. Chapter 3, co-authored with Professors Weili Ge, Dawn Matsumoto, and Jenny Li Zhang, examines the stock market consequences of disclosing accounting irregularities for U.S. listed foreign firms. We find that foreign firms experience significantly more negative two-day stock market reactions following restatement announcements than U.S. firms. Moreover, for a sample of foreign firms that are listed on both a U.S. and home country stock exchange, we find that restating firms’ U.S. investors react more negatively to the same restatement than their home-country investors. This differential market reaction appears related to firm-specific information frictions that are greater for foreign firms than U.S. firms. We also find a geographic contagion effect as non-restating firms from the same country experience significant stock price declines following restatements. Within a country-year, this contagion effect is concentrated among firms with lower accrual quality, suggesting that foreign firms’ restatements cause investors to alter their assessment of the earnings quality of non-restating firms from the same country. Collectively, our results suggest that accounting irregularities cause U.S. investors to reassess the information risk associated with foreign firms.

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This dissertation consists of two essays that present new evidence on the determinants and consequences of accounting quality. The first essay examines the consequences of earnings quality on a firm’s use of trade credit. I use earnings smoothness, asymmetric timeliness of earnings (conservatism), and earnings management to proxy for earnings quality. Consistent with high accounting quality reducing information asymmetry between firms and stakeholders, I hypothesize and find that firms with higher accounting quality are able to obtain more trade credit from their suppliers. Using a customer-supplier paired subsample, I show that the results are robust after controlling for suppliers’ characteristics. Moreover, using the 2007–2008 financial crisis as an exogenous shock to credit supply, I show that the positive relation between trade credit and accounting quality is more pronounced during a period of credit tightening. Furthermore, I find that the characteristics of transacted products also impact the relation—the association is stronger when companies purchase services or differentiated goods. Finally, I show that the positive association is concentrated in small firms and firms without credit ratings on senior debt. Overall, the evidence suggests that high earnings quality facilitates firms’ access to trade credit from suppliers.The second essay documents the effect of stock underpricing on firms’ financial reporting quality. I use mutual fund fire sales to identify relatively underpriced stocks and use performance-matched discretionary accruals to proxy for earnings management. Using difference-in-differences tests, I find that firms subjected to mutual fund fire sales increase their level of earnings management relative to unaffected firms. I also show that the effect is greater for firms experiencing more severe underpricing, firms with higher information asymmetry, and lower stock liquidity. In addition, earnings management is more pronounced in financially constrained firms. Finally, I examine whether earnings management helps stock price recovery, but find no evidence to support this hypothesis. In sum, the second essay finds that stock underpricing adversely affects firms’ financial reporting quality, an indirect effect of the stock market that has been previously overlooked.

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This study investigates the relation between accounting depreciation bias and equity valuation in a unique industry setting, Real Estate Investment Trusts (REITs). REITs report funds from operations (FFO), an industry standardized pro forma performance measure that is computed by excluding the depreciation expense of real properties from GAAP net income. Researchers have examined short-period samples and found inconclusive results on the relative ability of FFO and GAAP net income to explain the market value of equity. This dissertation attempts to explain their results by finding that depreciation expense, the largest reconciling item between FFO and net income, has different biases over the phases of real estate business cycles. This study uses modeling techniques to develop an industry-specific valuation model for REITs. In this model, the difference between the valuation coefficients on FFO and depreciation expense captures accounting depreciation bias and varies over the phases of real estate cycles. This model presents a theoretical link between accounting depreciation bias and the relative ability of FFO versus net income to explain the market value of equity. Using the REIT valuation model, this study empirically examines the impact of real estate cycles on accounting depreciation bias and on the relative ability of FFO and net income to explain the market value of equity. This study finds that FFO explains stock prices better than net income does in a market boom and that there is no significant difference in explanatory power between FFO versus net income in a market bust. Further results indicate that the valuation coefficients on FFO and depreciation expense have opposite sensitivities to a state variable that summarizes information on the real estate cycle phase during a year. These results partially reconcile the mixed results of prior studies across different time periods.

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In financial markets, anomalies refer to empirical regularities in which security returns deviate from what would be expected in an informationally efficient market. This dissertation investigates explanations for stock market anomalies related to accounting information as documented by Dichev (1998) and Piotroski (2000).Using Ohlson’s (1980) measure of bankruptcy risk (O-Score), Dichev (1998) documents a bankruptcy risk anomaly in which firms with high bankruptcy risk earn lower than average returns. My study first demonstrates that the negative association between bankruptcy risk and returns does not generalize to alternative measures of bankruptcy risk. Then, by examining the nine individual components of O-Score, I find that funds from operations (FFO) is the only component that is associated with returns. Furthermore, I show that the return-predictive power of FFO is due to cash flows from operations. Taken as a whole, this study provides evidence that Dichev’s bankruptcy risk anomaly is a manifestation of investors’ under (over)-pricing of cash flows (accrual) component of earnings, i.e., the accrual anomaly documented by Sloan (1996).The second study investigates the effects of two potentially problematic research design choices which are often made in accounting-based studies of anomalies. I explore these issues by re-examining the results in Piotroski (2000), who finds that a simple, financial statement-based heuristic, when applied to a subset of firms with high book-to-market ratios, can discriminate between the firms that will eventually provide high returns and those that will be poor performers. I find that the relationship between Piotroski’s fundamental signals and subsequent returns is partly driven by the choice of return accumulation periods and the use of equally weighted re-turns. When the research design controls for both problems, the relationship disappears. Because the methods used in Piotroski are typical of those often employed in the accounting literature, this study suggests that evidence of profitable trading strategies and market inefficiency in the literature is likely to be overstated.

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This thesis consists of two studies in the area of executive compensation. The first examines the effect of boards of directors’ characteristics on the degree of compensation efficiency with respect to the use of private information. I predict and find that boards’ competence both in information acquisition and in monitoring influence the extent to which boards use private performance measures in CEO compensation. Specifically, smaller and more independent boards with their CEOs as the board chair are more efficient in exploiting private performance measures. Furthermore, the better a board balances its information role with its monitoring role, the more efficient it is in exploiting private performance measures. No asymmetry is found in rewarding and punishing CEOs based on private information. The second study investigates the mechanism to inflate the value of executive stock options after Sarbanes-Oxley Act Section 403 (SOX 403), which requires that executive option grants be reported to the SEC within two business days following the grant day. As this requirement largely restricts backdating of executive option grants, I examine whether firms that previously backdated resort to alternative strategies after SOX. Using firms that were relatively free from backdating before SOX as a control group, I find that in the post-SOX period previous backdating firms exhibit a significantly larger return reversal around option grant dates, suggesting some sort of opportunistic behavior is still going on in these firms. Furthermore, I find that post-SOX option grant filings of previous backdating firms are as timely as those of the non-backdating control group, and that the large return reversals are associated with a pattern consistent with strategic timing of grants and disclosures; that is, a larger proportion of option grants are issued right after bad news (before good news) than right before bad news (after good news). These findings suggest that firms that previously backdated engage in strategic timing as an alternative mechanism to lower the grant-date stock price in the post-SOX period.

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Valuation models are used extensively in Finance and Accounting to investigate various empirical questions. Conventional valuation models express firm value as a function of discounted dividends, discounted abnormal earnings, discounted cash flows, or price multiples. One limitation from using these models is that they don’t capture unique industry valuation characteristics. However, modeling techniques can be used to modify a conventional model in order to reflect specific business processes. In the first chapter of this thesis I use modeling techniques to develop an industry-specific valuation model for pharmaceutical firms. This allows me to explore how investments in research and development, advertising, and production facilities create value for firms in this industry. In particular, the techniques used in this paper allow me to estimate and explore the economic rents generated by these investments. My valuation model is based on the cash inflows and outflows of a typical pharmaceutical firm. In the second chapter of this thesis I test whether the model is improved by adding a system of accounting accruals. I also compare the performance of my valuation model to a model with summary accounting measures to assess the importance of data disaggregation. The value of advertising investments is likely to have changed in the period investigated in this thesis because on August 8, 1997 the Food and Drug Administration announced that it would relax the rules on direct-to-consumer advertising of prescription drugs. The last chapter of this thesis is an event study of this regulatory change. I investigate the effect of the announcement on share price as well as the firm characteristics associated with the price reactions. Each chapter in this thesis answers a different question with respect to valuation in the pharmaceutical industry.

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No abstract available.