Knowledge that Transforms

Abstract This paper examines the effect of earnings announcements on information asymmetry as perceived by specialists. We use changes in quoted bid‐ask spreads and depths (relative to the average value in the non‐announcement period) as proxies for changes in information asymmetry in the market. To our knowledge, we are the first to employ a model that captures the simultaneous nature of the specialists' choice of spreads and depths in reaction to earnings news. We provide evidence that spreads are wider and depths are smaller before the release of earnings announcements. We also find that changes to depths are greater for announcements of quarterly earnings than for announcements of annual earnings and changes to spreads persist longer into the post‐announcement period when announcements are made outside trading hours. These changes to spreads and depths persist when earnings announcements are made after trading hours.

This paper provides a theoretical explanation and consistent empirical evidence for the increase in the contemporaneous correlation between returns and aggregate earnings as the return interval is lengthened. Consistent with intuition and with Easton, Harris, and Ohlson 1992, the analysis shows that aggregation over time renders the lag in accounting recognition relatively less important and thus improves the returns-earnings R2. Interestingly, the analysis also reveals that aggregating earnings over longer periods increases the positive covariance between aggregate earnings and the accounting lag, which may further increase the R2. This positive covariance can lead to an earnings coefficient greater than one over some range of aggregation, which is consistent with the findings of Easton et al. that over the 10-year interval the returns-earnings regression slope coefficient is greater than one (1.7). The empirical results highlight the fact that the slope coefficient, which is greater than one and increasing with the interval, accounts for much of the increment to the returns-earnings R2. In fact, constraining the slope coefficient to be one results in an R2 of 11 percent for the 10-year interval, which is considerably lower than the R2 of 47 percent when the regression is unconstrained. Hence, the positive covariance between current earnings and the accounting lag, rather than the diminishing effect of the accounting lag, appears to be the dominant explanation for the observed high R2 over long intervals.

Abstract This study examines whether the length of the relationship between a company and an audit firm (audit‐firm tenure) is associated with financial‐reporting quality. Using two proxies for financial‐reporting quality and a sample of Big 6 clients matched on industry and size, we find that relative to medium audit‐firm tenures of four to eight years, short audit‐firm tenures of two to three years are associated with lower‐quality financial reports. In contrast, we find no evidence of reduced financial‐reporting quality for longer audit‐firm tenures of nine or more years. Overall, our results provide empirical evidence pertinent to the recurring debate regarding mandatory audit‐firm rotation — a debate that has, to date, relied on anecdotal evidence and isolated cases.

Abstract The relation of competition and cost accounting has been the subject of conflicting prescriptions, theories, and empirical evidence. Practitioner literature and textbooks argue that higher competition generally requires more accurate product costing. Theoretical economic analysis, in contrast, predicts that the optimal level of product‐costing accuracy is sometimes higher at lower levels of competition. Results of survey research are inconsistent, suggesting a need for further identification of conditions under which higher competition leads to more accurate product costing. This study shows experimentally that individuals' choices of the level of product‐costing accuracy depend not only on the current level of competition but also on the previous level of competition — that is, on an interaction between market structure (monopoly, duopoly, and four‐firm competition) and market history (increasing versus decreasing competition). In the experiment, subjects decide on the quantity of data to collect at a pre‐set price per datum to support more accurate product‐cost estimates. Subjects collect the most cost data (i.e., choose the most accurate product costing) in monopoly, collect the least in duopoly, and an intermediate amount in the four‐firm market, consistent with the pattern of optimal cost‐data collection in Hansen's 1998 model. The process of convergence to the optimum differs significantly across market types and market histories, however. Subjects who begin in four‐firm competition adapt more successfully to change than those who begin in monopoly. The lowest levels of decision performance occur when ex‐monopolists face their first competitor: they overreact to this first encounter with competition and overspend on cost data.

Abstract “Synergy” implies that the value of activities undertaken jointly is greater than the sum of the values of the individual activities. Reasons cited for synergy include economies of scale, benefits due to vertical integration, and efficiency gains from shared inputs and skills. This paper shows that incentive (control) reasons alone can make activities synergistic. The result is derived in a model of adverse selection with risk‐neutral participants and linear technology. The linearity in the setting removes any obvious benefits to undertaking activities in tandem. Synergy gains are attributed to a convexity in the principal's payoff introduced by the activities' impact on the production versus rents trade‐off.

Abstract Gibbins and Trotman's study both explores reviewer attributes that auditors judge to influence review quality and replicates earlier, largely experimental findings about preparer and reviewer decision behavior. Such exploration and intra‐method replication create opportunities to refine theory and better design future experimental and nonexperimental studies. Naturally, as with any study, the opportunities that this study creates are not without bounds. To help in thinking about these bounded opportunities, this discussion raises four topics that I have entitled “retro‐spective biases”, “stylization perceptions”, “manager styles”, and “real‐time review complexities”. After discussing these topics in turn, I end with a short summary.

Our interest in this study is the relative informativeness of earnings announcements reported before and after Form 8-K disclosures of the reason for an auditor change. We appeal to several models that predict that the market's response to an earnings surprise is positively related to the perceived precision of the earnings report. We predict that the Form 8-K reason disclosures aid investors in updating their expectations of earnings precision by providing useful information about the financial reporting process that produces the earnings report. For 802 auditor changes from late 1991 through late 1997, the average price response per unit of earnings surprise is lower subsequent to an auditor change for companies that switched for disagreement-related or fee-related reasons and higher for those that switched for service-related reasons. This paper provides further evidence on the effects of differential earnings quality on differences in the returns-earnings relation across companies and over time as well as the efficacy of Form 8-K disclosures of reasons for auditor changes.

Abstract This paper provides a theoretical explanation and consistent empirical evidence for the increase in the contemporaneous correlation between returns and aggregate earnings as the return interval is lengthened. Consistent with intuition and with Easton, Harris, and Ohlson 1992, the analysis shows that aggregation over time renders the lag in accounting recognition relatively less important and thus improves the returns‐earnings R 2 . Interestingly, the analysis also reveals that aggregating earnings over longer periods increases the positive covariance between aggregate earnings and the accounting lag, which may further increase the R 2 . This positive covariance can lead to an earnings coefficient greater than one over some range of aggregation, which is consistent with the findings of Easton et al. that over the 10‐year interval the returns‐earnings regression slope coefficient is greater than one (1.7). The empirical results highlight the fact that the slope coefficient, which is greater than one and increasing with the interval, accounts for much of the increment to the returns‐earnings R 2 . In fact, constraining the slope coefficient to be one results in an R 2 of 11 percent for the 10‐year interval, which is considerably lower than the R 2 of 47 percent when the regression is unconstrained. Hence, the positive covariance between current earnings and the accounting lag, rather than the diminishing effect of the accounting lag, appears to be the dominant explanation for the observed high R 2 over long intervals.