Two essays on innovations and accounting
Creators: name: Tukue, Tesfalidet
Publisher: name: No Publisher Supplied
Year: 2017

description: This dissertation consists of two essays on innovations and accounting.  The first essay aims to tackle the long-standing debate on the association between business risk and audit fee (e.g., Johnstone 2000; Morgan and Stocken 1998; Simunic and Stein 1994;  Seetharaman, Gul, and Lynn ; 2002). Much of the prior literature on business risk focuses on litigation risk, which is the risk of incurring liability payments and the risk of damaged reputation for the service auditors provide. This study also follows the approach used in litigation risk studies but examines a topic that, to my knowledge, has not been explored in the literature. I examine whether the business risk (patent infringement risk) of innovation firms that may or may not be reflected in the financial reports, are associated with audit fees. The abstract nature of patents and institutional inefficiency of the existing patent system make patenting activities risky endeavors.  First, the abstract nature of patents makes it challenging to clearly identify one patent from another; and existing patent system fails to establish clear boundaries and efficient guidelines to protect patented inventions. As a result, more than one entity can use or claim an invention at the same time, resulting in frequent and costly infringement suits. Second, patent infringement is a “strict liability” tort, and liability on patent infringements can be imposed on a party regardless of the party’s knowledge or intention (such as copying or bad faith or negligence).  According to the 35 U.S. Code 271, a patent infringement occurs when another party makes, uses, or sells a patented item without the permission of the patent holder. Consequently, everyone up and down the supply chain could be sued for infringement. i.e., distributors can be sued for selling a patented invention, whereas end users can be sued for using the invention. Therefore, patenting activities involve potential business risks almost at every stage — from invention to production, to licensing and distribution. In addition to the direct legal cost, the aggregate costs of infringement suits include business costs such as loss of market share, management distractions, preliminary injunctions, negative publicity, temporary product boycotts, higher regulatory scrutiny and strained relationships with customers and industry members. Using the patenting activities and audit fees data of 3,688 firms in the U.S., I hypothesize and find that audit fees are higher for clients engaged in more patenting activities including the number of patents granted in a year and non-self-patent citations.   The second essay examines whether internal controls enhance or impede firm innovations. Innovations begin at the individual level; and individual knowledge is transferred to the organization’s knowledge base only when it is shared and assimilated into routines, documents, and practices (Autio, Sapienza, and Almeida 2000).  Therefore, as procedures designed to improve operational efficiency and effectiveness, internal control routines, documents and practices put in place can influence the innovation productivity of a firm. The COSO framework and recent studies in accounting suggest that strong internal controls increase investment efficiency and operational efficiency in a firm (COSO 1992; Cheng et. al. 2013; Feng et al. 2013). Literature from Total quality Management (TQM) and operations research also suggest that strong internal controls provide preventive mechanisms that minimize operating cost and business risk in the organization by eliminating costly and risky steps.  Consequently, effective internal controls can enhance firm’s innovation productivity through increased operational efficiency and effectiveness, and reduced business risk For instance, effective control and monitoring mechanisms can minimize operating costs and operational risks related to defects, waste, reworks, delays, customer dissatisfaction and system failures; whereas strong information and communication system can facilitate a smooth and speedy transfer and assimilation of knowledge within and across units of organization.  On the other hand, internal controls can also impede innovations as higher compliance costs divert scarce resources and management time from innovative undertakings. Moreover, in dynamic environments, formalized controls and monitoring routines may be far from optimal (Arthur 1994; Levitt and March 1988); and excessive focus on efficiency and effectiveness may induce certain dysfunctional behaviors in a firm that impede innovations including learning traps, structural inertia (rigidity), and compartmentalized thinking (Argyris &amp; Schon, 1998; Dosi, 1998).  Using a sample of 4,227 US firms that reported internal control under SOX 404, I find that firm innovation, measured by patenting activities, is significantly lower among firms with material internal control weaknesses relative to firms without such weaknesses. In addition, I find that firms that remediate their material internal control weaknesses subsequently experience an increase in innovation productivity.