Knowledge that Transforms

We examine the properties of a returns‐based representation of earnings quality, estimated from firm‐specific asset‐pricing regressions augmented by an earnings quality mimicking factor. The coefficient on the earnings quality factor (the “e‐loading”) captures the sensitivity of the firm's returns to earnings quality in a given year or quarter, analogous to beta as a measure of the sensitivity of returns to market movements. Relative to other proxies for earnings quality, e‐loadings can be calculated for larger samples of firms and can be estimated for shorter intervals at any point in time. Along all dimensions examined, we find that e‐loadings perform well in capturing notions of earnings quality.

We study the determinants of organizational slack in large decentralized firms and focus in particular on how management accounting systems (represented by business unit controllers) affect slack. We rely on an adverse selection model to derive several predictions and to motivate our tests. Consistent with this framework, we find that organizational slack (measured by achievability of business unit managers' performance targets) is higher in settings where business unit controllers focus relatively more on providing decision-making information to business unit managers than on providing information for corporate control. We also find that organizational slack is persistent over time and positively associated with business unit growth, our proxy for the extent of information asymmetry between corporate headquarters and local business unit management.

In this paper, I extend the organizational design literature by examining how the delegation choice is affected by the ability to resolve the incentive problem caused by this delegation. Based on the seminal papers by Grossman and Hart (1986) and Holmstrom and Milgrom (1994), I argue that the ability to resolve the incentive problem depends on the contractibility of financial performance measures versus non-financial performance measures, where the contractibility depends on the performance measure properties sensitivity, precision, and verifiability. The empirical results show that, if financial performance measures are good (poor) incentive measures, i.e., high (low) on sensitivity, precision, and verifiability, then using these measures for incentive purposes increases (decreases) delegation. Overall, the results are consistent with the argument that firms design their organizational structure around the quality of contractible performance measures.

We present a rational model of earnings management. An informed manager, whose compensation is linked to the stock price, trades off the benefit of boosting the stock price by inflating the reported earnings against the costs of such manipulation. The investors rationally interpret his actions and adjust the price accordingly. When the distribution of true earnings and the compensation scheme are smooth, the conventional equilibrium in this signaling framework is also and fully revealing. In this paper, we show that in the same smooth environment there exist equilibria in which kinks and discontinuities emerge endogenously in the distribution of reported earnings. The manager optimally chooses a partially pooling strategy, introducing endogenous noise into his report. The resulting vagueness enables the manager to reduce the average manipulation costs. The equilibrium has perfect revelation of earnings in the right and left tails of the distribution, while for intermediate earnings realizations we get one or more pools that manifest themselves as discontinuities in the distribution of reported earnings. We study the properties of these partially pooling equilibria and suggest applications to financial reporting.