Kin Lo

Associate Professor

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Graduate Student Supervision

Doctoral Student Supervision (Jan 2008 - Nov 2020)
Essays on politically connected firms (2017)

This thesis explores a number of issues related to politically connected firms in two separate chapters. I follow Goldman et al. (2009), defining politically connected firms as those with at least one former politician serving as member of its board of directors, and construct a sample containing the S&P 500 firms between 2004 and 2013. The first chapter explores why firms seek these political connections, and how they benefit from two direct value extraction channels: government procurement and subsidies. I find that firms that aim for government contracts seek executive branch connections, while those that face heavy regulations target congressional connections. Next, I show that politically connected firms do get more government contracts and subsidies. Firm performance (using accounting based measures) suffers with government contracts and subsidies, and political connections fail to increase or decrease this negative relation, which suggests effective safeguards against overpricing and cronyism. However, politically connected firms do seem to enjoy a temporary increase in future ROA, when government contracts are taken into consideration. The second chapter asks if politically connected firms pay higher audit fees, and explores the underlying reasons. Prior studies have mixed implications on how risky these clients are for auditors. On the one hand, some studies suggest politically connected firms have lower accounting quality and face higher political risk, hence incur higher audit fees. On the other hand, less investor pressure and lower litigation and bankruptcy risks would decrease audit fees for firms with political connections. I find that politically connected firms do pay higher audit fees, and the effect is stronger for those with executive branch connections. Neither lower accounting quality nor higher political risk is found to be the underlying reason. The fact that many politically connected firms are government contractors, who are subject to additional regulations and government audit, is found to be the main factor for this difference in audit fee.

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Essays on Firms' Accounting Quality (2015)

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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The Economics of Market and Regulatory Enforcement in Auditing (2014)

Within the framework of classical auditing theory (Simunic, 1980), an auditor is motivated to exert more effort in the presence of greater litigation risk imposed by courts or regulators. A key element underexplored by literature based on the auditing theory is how the detection of audit failure or non-compliance of auditing standards. This dissertation uses two natural experiments to illustrate the importance of auditor misconduct detection. The first essay exploits mergers of brokerage houses in order to examine whether an exogenous loss in analyst coverage affects audit effort. Security analysts, who are considered to be sophisticated users of financial statements, scrutinize auditor-verified financial statements. I predict that a change in perceived analyst scrutiny will cause auditors to change the effort that they expend in achieving high auditing standards. Using the audit fee as the proxy for audit effort, I find that firms which lose an analyst experience a reduction in audit fees, compared to similar firms that do not lose an analyst. Moreover, this effect is stronger for smaller firms. Overall, the results support the hypothesis that analysts contribute to auditor discipline. The second essay of this thesis makes use of an announcement by the PCAOB on May 18, 2010, which indicates that the PCAOB oversight of foreign auditors has been restricted, as an exogenous shock, in order to identify the perceived effectiveness of cross-border enforcement of audit oversight. Analyzing a comprehensive sample of foreign companies registered with and reporting to the SEC, I document that 1) the “inability” announcement had a spillover effect: the stock market reacted negatively not only for companies mentioned in the “inability” list, but also for other U.S. listed foreign companies; 2) the market reactions to the announcement varied with companies’ home country institutional strength and firm-level characteristics; 3) US-listed foreign companies’ bid-ask spreads increased following the announcement and the changes in bid-ask spreads also varied with companies’ home country institutional features. The evidence supports a prediction of the theory developed herein: that the value creation of adherence to a stringent auditing regime should be more pronounced for companies from countries with weaker institutional strength.

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An investigation of certain accounting-related stock market anomalies (2012)

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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Liquidity shocks and firms' financial reporting quality (2012)

Problems of endogeneity often cloud interpretation in studies on the relation between firm disclosure and external financing. This dissertation uses two different liquidity shocks as natural experiments to provide new evidence in this research area. The first essay makes use of tightened liquidity supply in the banking industry following monetary contractions for examining the impact of credible accounting information on corporate financing and investments. Theory suggests that asymmetric information will restrict banks’ ability to raise additional financing to offset the liquidity losses caused by monetary contractions. The attendant liquidity shortfall will force banks to hold back their investments (i.e., lending). Using external audits to proxy for accounting credibility and a sample of 9,910 small banks for which audits are voluntary, this paper finds that audited banks enjoy greater access to outside financing than other banks. Correspondingly, the lending of audited banks is less affected by policy-induced liquidity issues. Further results indicate that audited banks disclose higher quality accounting information that gives them greater reporting credibility and reduced information problems. In summary, this paper offers new evidence that credible disclosure facilitates corporate financing and investments. The second essay identifies negative shocks to the supply of bank loans as exogenous events that motivate firms’ disclosure of management forecasts. Following loan supply distortions, borrowers have greater motives to finance through alternate capital sources. If forecasts enhance firms’ access to the public capital markets, borrowers have incentives to increase forecasts to facilitate capital raising to substitute for previously available loans. The test exploits the emerging-market financial crises in the late 1990s. These events were plausibly external to the U.S. loan markets, yet their effect was transmitted through U.S. banks' large loss exposures to the crisis areas which ultimately limited the lending of exposed banks. Accordingly, I predict and find evidence consistent with borrowers of exposed banks increasing forecasts following the crises to ease access to public financing. Further, these borrowers changed forecast characteristics in ways consistent with the use of forecasts to reduce investor uncertainty. Overall, these disclosure changes provide new evidence on how capital supply affects firms' incentives to issue forward-looking information.

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Essays on Executive Compensation (2010)

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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