Professor Pincus’s research is empirical-archival in nature and spans an eclectic set of (sometimes overlapping) topics. His primary research interests over the review period included the following areas, which overlap to some extent: (a) the interaction of financial reporting and income taxes, including “book-tax” differences to detect earnings management, predict earnings growth and future stock returns, and estimate market-based measures of firm risk; (b) the relation between accounting information and stock market variables, especially including legislative and regulatory event studies and capital market efficiency with respect to accounting information; (c) US and international financial accounting policies; (d) the impact of complex information systems on auditing and accounting; and (e) other audit research. Recent research papers and projects are discussed below under each of these categories.
Interaction of financial reporting and income taxes.
Book income (BI) as reported in a firm’s financial statements generally differs from taxable income (TI) as reported to the tax authorities. The difference between BI and TI is commonly referred to as the book-tax difference (BTD).
Phillips, Pincus, & Rego (The Accounting Review 2003) is the first of a series of book-tax difference papers demonstrating that deferred income tax expense is incrementally useful beyond accrual-based measures (and sometimes dominates accrual measures) in detecting upward earnings management to avoid reporting an earnings decline or a loss. Deferred tax expense captures temporary differences between income reported for financial reporting purposes and income reported for tax purposes. In addition to providing evidence of an alternative indicator of earnings management, one implication of the Phillips, Pincus, & Rego study is that if book income and tax income were required to conform, the BTD indicator of earnings management would be lost.
Badertscher, Phillips, Pincus, & Rego (The Accounting Review 2009) extend book-tax difference research by investigating how managers manipulate earnings, focusing on two income-increasing earnings management strategies: “book-tax” conforming vs. nonconforming reporting. The latter is when firms report higher BI than TI (and thus would appear to “have their cake and eat it, too”); note that only book-tax conforming earnings management affects current income taxes. We examine firms that misstated BI due to accounting irregularities and had to restate their earnings. The results indicate that misstating firms (i) predominantly employ nonconforming earnings management strategies to increase reported earnings, and further that firms (ii) behave as if they trade off the net present value of tax benefits against the net expected costs of being detected as an earnings manager.
Chi, Pincus, & Teoh (The Accounting Review 2014) investigate whether the ratios TI/BI and particularly its temporary component, denoted TEMP/BI, reflect greater managerial discretion than TI/BI, contain useful information about future earnings growth that is mispriced by investors. The study finds evidence that TI/BI and TEMP/BI do predict future earnings growth and future abnormal stock returns. The authors then examine whether short arbitrageurs and firm insiders trade on personal account in a manner consistent with arbitraging the mispricing of TI/BI and TEMP/BI. They find evidence consistent with short sellers and insiders profiting from unsophisticated investors’ mispricing of TI/BI, and especially TEMP/BI, and discuss how accounting disclosure for income taxes akin to a ‘‘sunshine policy’’ may reduce mispricing of BTDs by less sophisticated investors and improve capital market efficiency.
Dhaliwal, Lee, Pincus, & Steele (Journal of the American Taxation Association 2017) study whether TI provides incremental information about firms’ operating risk beyond the variance of BI and variance of operating cash flows. They develop TI-based variance and covariance measures that are useful in assessing risk in a simple earnings predictability model. In the empirical tests, these TI-based measures incrementally explain cross-sectional variation in the predictability and variability of future pre-tax BI, and are associated with predictable variation in market-based measures of firm risk. The findings shed light on how accounting information impacts investors’ assessment of firm risk as well as improving our understanding of the extent and nature of information contained in TI. An implication of the results is that conforming book and tax reporting would eliminate the ability to compute the variables we demonstrate are relevant to firms’ risk assessments.
In Gleason, Pincus, & Rego (Journal of the American Taxation Association 2017) the authors investigate consequences of income tax-related material weaknesses in firms’ internal controls over financial reporting that their external auditors identify and disclose. They hypothesize that the presence of internal control material weaknesses (ICMWs) over the tax function makes earnings management to meet or beat financial analysts’ earnings forecasts through the income tax accrual (so-called “last chance” earnings management) easier to implement relative to firms with non-tax-related ICMWs. They also predict that the remediation of tax-related ICMWs has the effect of constraining earnings management through the tax accrual. The results provide support for the authors’ predictions. They also find that earnings management using the tax accrual is concentrated in the early years of our sample period, that is, in the initial Sarbanes-Oxley Act (SOX) implementation period. The results suggest that tax-related ICMWs were initially associated with greater tax-expense management and that SOX internal control assessments, at least regarding tax-related ICMWs, subsequently reduced tax-accrual earnings management.
The relation between accounting information and stock market variables.
The efficient market hypothesis (EMH) was imported into the accounting literature from finance in the late 1960s and for many years was the dominant paradigm explaining the relation between capital market variables and accounting information. However, results anomalous to market efficiency have been reported (in finance as well as in accounting); for example, see the Chi, Pincus, & Teoh (The Accounting Review 2014) study discussed above. Still, the EMH can be a useful first approximation of stock price behavior to new information, and as such can potentially serve as a benchmark for assessing capital market research results. Further, event studies arguably make little sense without assuming a reasonable degree of market efficiency from which to infer investor reactions to anticipated regulatory or legislative changes; they place a premium on precise event dating and often the most valid results from event studies are based on cross-sectional analyses.
Pincus, Rajgopal, & Venkatachalam (The Accounting Review 2007) investigate whether the “accrual anomaly,” characterized by U.S. stock prices overweighting the role of accrual persistence, is a local manifestation of a global phenomenon. The authors consider stock markets in 20 countries. Based on firm-level data on a country-by-country basis, they document that the accrual anomaly occurs in Australia, Canada, the U.K., and the US, and also in a sample of firms that are domiciled in countries where they do not detect the anomaly but that have American Depository Receipts (certificates representing an interest in their shares) that are traded in the US. They also find, based on country-level data, that the accrual anomaly is more likely to occur in countries having a common law tradition, allowing more extensive use of accrual accounting, and having more diffuse ownership of shares. Additional analyses reveal that earnings management and barriers to arbitrage best explain the occurrence and persistence of the accrual anomaly.
US and international financial accounting policies.
Accounting policy choice – voluntarily chosen as well as mandated – has been a research interest of Professor Pincus’s entire career.
The Sarbanes-Oxley Act of 2002 (SOX) is the most important US legislation dealing with financial reporting and auditing since the 1930s. It was passed in the aftermath of the corporate accounting frauds of the early 2000s. The law’s stated purpose is to “protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws.” Li, Pincus, & Rego (Journal of Law & Economics 2008) is a legislative event study that examines the relation between stock market reactions to legislative events leading to the passage of SOX and the extent of firms’ earnings management. In cross-sectional tests the authors find evidence consistent with investors anticipating that SOX would constrain accruals-based earnings management and enhance the quality of financial statement information more, the more that firms had previously managed earnings.
Impact of complex information systems on auditing and accounting.
The digital and IT revolutions have dramatically changed the way people and organizations function and communicate, and Professor Pincus is very interested in exploring how this is affecting accounting and auditing.
Pincus, Tian, Wellmeyer, & Xu (Contemporary Accounting Research forthcoming), examine whether the presence and extent of client firms’ enterprise system (ES) implementations are related to the quality and efficiency of their external auditors’ work. ESs are widely used to support business processes along the enterprise value chain, and prior research shows that ESs, by automating, standardizing, and integrating business functions and making information about day-to-day activities available, enhance operational transparency and improve a client firm’s internal information environment. However, the prevalence of ESs and their increased complexity have also brought new challenges and thus increased audit risks to external auditors. Using proprietary archival data on ES implementations and controlling for self-selection, the study finds overall that ES implementations improve the quality and efficiency of current and future years’ external audit work. There generally are fewer restatements, a greater likelihood of issuing going concern opinions to firms that subsequently go bankrupt, greater accruals-based auditing quality, a lower likelihood of Form 10-K filing delays, and lower audit fees. However, with regard to evidence in the literature – that auditors generally do not identify ICMWs in advance of restatement announcements, and that auditors issue too many going concern opinions to clients that survive – the study finds no evidence that ESs help auditors overcome these tendencies. The authors do show that the benefits of ESs generally increase with the scope of implementations and are generally greater when the ES includes accounting and finance systems.
