Three essays on financial information and capital market

Abstract

This dissertation consists of three distinct but related essays examining financial information in the capital market. The fundamental purpose of accounting is to provide useful financial information for decision makers (Scott 2014). The main stream of accounting research examines whether and how the quality of financial information can be improved in terms of different attributes, including persistence, reliability, conservatism, earnings smoothness, target beating (Dechow, Ge, and Schrand 2010), and comparability (Franco, Kothari, and Verdi 2011). However, one research area under development is to examine the value of financial information. Drawing literature from both accounting and finance, I refine my interest of research in the value of financial information in capital market. I examine the value of tax avoidance in the post-IPO capital market in my first essay. In the second and third essay, I focus on an increasingly prevalent investment strategy – hedge fund activism. The second essay shows the value of auditing services, which provides reasonable assurance to information quality, to target firms of activist hedge funds. The third essay demonstrates the value of sell-side analysts, who provide ideas to activist hedge funds in establishing their objectives and tactics.

In the first essay I examine whether and to what extent industry peers use tax avoidance as a strategic mechanism to maintain their relative competitive positions. I exploit a unique setting where a relatively large private firm imposes significant competitive pressure on its industry peers by going public (an IPO) and revealing its competitive advantages. I find that peer firms increase their tax avoidance after large IPOs. I posit and find that tax avoidance serves as a financing strategy to generate internal funds as well as an earnings-management strategy to modify financial information. In addition, I find that the impact of IPOs on peer firms’ tax avoidance is more salient for industries with lower information intensity.

The second essay investigates the relationship between auditors and target firms of hedge fund activism. The extant literature focuses on the effect of hedge fund activism on shareholders but overlooks other stakeholders. I fill in this literature gap by investigating the effect on auditors. I find that the governance effect of hedge fund activism spillovers to incumbent auditors, leading to 4.08% increase in audit fees. Auditor turnovers do not significantly change, meaning that hedge funds do not seek new auditors. The governance spillover effect is through revealing internal control weaknesses and changing audit committee members in target firms. Further tests show that the increased audit fees are allotted to more audit effort and reduce the likelihood of restatements, suggesting the improvement of audit quality. My findings support the value creation effect by hedge fund activism. Hedge fund activism and auditors are complementary at strengthening corporate governance.

The third essay is closely related to the second essay and examines the origin of hedge fund activism. Recent literature has shown hedge fund activism to be an important external corporate governance mechanism. Sell-side analysts, however, provide idea generation and analysis to buy-side clients including hedge funds. I find that pre-intervention analyst reports are valuable to investors, leading to negative stock market reaction. I use textual analysis to introduce a new dictionary to identify the activism objectives and tactics of Brav, Jiang, Partnoy, and Thomas (2008) within analyst reports. I show that pre-intervention sell-side reports contain significantly more language related to subsequent activism. Higher activism dictionary content in pre-intervention sell-side reports is positively correlated with activism-date target stock performance and predicts multiple activist interventions. My results suggest that the critical voice of sell-side analysis reveals target firm flaws that influence subsequent hedge fund intervention outcomes.