DEFINITION: EXPLANATORY LANGUAGE Explanatory language is the additional wording that auditors use to emphasize circumstances or matters encountered during an audit. It can signal risk, but most investors don’t heed it as closely as they should.
CARBON TAX COULD YIELD UNEXPECTED BENEFITS G UOMING LAI, ASSOCIATE PROFESSOR, INFORMATION, RISK, & OPERATIONS MANAGEMENT
I CO N M A D E BY F R E E P I K
Rival supermarkets, battling for market share, open across the street from each other. This means two supply trucks drive to the same area (and idle their engines) when one truck might have been enough to serve the volume of sales for that area. The extra pollution produced, from both suppliers and consumers, contributes to global warming. Enter the carbon tax. Opponents say it would raise production costs and put some companies out of business. According to Associate Professor Guoming Lai, “That’s actually true. But the country as a whole would still be better off.” The reason, according to Lai and his co-authors, is that artificially cheap transportation leads to inefficient and wasteful retail networks. The researchers examined the effect a carbon tax would have on rival retail chains and found that the more competitive a market is, the more beneficial a carbon tax would be. As a result, firms would be forced to modify their supply chains to stay in business.
SPRING 2016
STOCK PERFORMANCE: RANKING COUNTS MORE THAN INDEX
NONSTANDARD LANGUAGE IN AUDIT REPORTS CAN SIGNAL RISK
INESSA LISKOVICH, ASSISTANT PROFESSOR, FINANCE
JAIME SCHMIDT, ASSISTANT PROFESSOR, ACCOUNTING
What happens when a stock joins the top ranks of an index? Researchers have long suspected that performance is influenced by the dynamics of stock trading, but according to Assistant Professor Inessa Liskovich, who has worked as a trader for Goldman Sachs, “It’s been hard to prove it’s actually going on.” To test the theory, Liskovich and colleagues looked at the Russell 1000 and Russell 2000, indexes that list the largest American public companies based on market capitalization. Each year, up to 10 percent of stocks switch places between the two indexes. The researchers found that when a stock moved from the top of the Russell 2000 to the bottom of the Russell 1000, it averaged 5.4 percent lower returns. But stocks that moved into the top of the Russell 2000 averaged 5 percent higher returns and were in greater demand among mutual funds managers. The takeaway? It’s the ranking, not the index, that counts.
While investors often complain that audit reports are boilerplate and uninformative, research by Assistant Professor Jaime Schmidt suggests the opposite — that buried within the auditor’s language are clues to financial reporting risk. Most audit reports are unqualified, indicating that with reasonable assurance the financial statements should be presented fairly in all material respects in accordance with generally accepted accounting principles. However, in an analysis of more than 30,000 unqualified audit reports issued for public companies between 2000 and 2009, her research finds that auditors often add nonstandard (or “explanatory”) language to unqualified audit reports and that the financial statements associated with such language are 18 percent more likely to be subsequently restated within two years than those without. Schmidt advises investors to look for any nonstandard language. “Read the footnote it’s pointing to and see if it’s useful.”
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