Knowledge that Transforms

In this paper, the principal rewards an agent’s farsighted effort both in the short and long term, with the short‐term reward based on a noisy, forward‐looking performance measure and the long‐term reward based on a potentially less noisy, trailing performance measure. The main result is that optimal contracting weights depend on the agent’s employment time horizon: the shorter the agent’s employment horizon the greater the emphasis on the forward‐looking performance measure and vice versa. This implies that contracting on forward‐looking performance measures can be valuable in mitigating any adverse long‐term effects of employees myopically focusing on short‐term trailing performance measures.

The AICPA Special Committee on Financial Reporting has urged disclosure of relevant forward‐looking information on risks and opportunities to supplement conventional financial statements. We conduct a laboratory market experiment to assess the effects of such disclosures on capital allocation decisions. We develop two sets of competing hypotheses regarding how capital markets react to supplemental disclosures. One set is based on the assumption of semi‐strong market efficiency, while the other posits that the bounded rationality of individual traders leads to inefficient market prices. We find that explicit disclosure of management’s best estimate of an uncertain quantity improves market efficiency, even though this disclosure is redundant with information in financial statements. Second, we find disclosure of an upper bound of management’s estimate has the potential to bias security prices upward, while informationally equivalent disclosure of both upper and lower bounds removes this bias. These results suggest that experimental market reactions to these supplemental disclosures are inconsistent with market efficiency. Supplemental analyses of individuals’ price predictions and trading behavior support our conclusion that inefficiencies are at least partially attributable to individual information processing biases.

Despite extensive research on the determinants of external audit fees, there is little empirical evidence on the effect of internal audit contribution on the external audit fee. Using a cross‐sectional regression model based on prior audit fee research, this study provides evidence that internal audit contribution is a significant determinant of the external audit fee. Further, a second model that provides evidence on the determinants of internal audit contribution is developed and tested. This second model indicates that internal audit contribution is influenced by internal audit quality and, conditional on the level of inherent risk, the availability of internal audit and the extent of coordination between internal and external auditors. These results are based on a unique data‐set comprised of publicly available data matched with survey responses from internal and external auditors affiliated with 70 non‐financial services Fortune 1000 firms. The sample includes all of the former “Big 6” international accounting firms and clients from twenty‐nine different industries.

This paper examines whether firms emerging from conglomerate stock breakups are able to affect the types of financial analysts that cover their firms as well as the quality of information generated about their performance. Our sample comprises 103 focus‐increasing spin‐offs, equity carve‐outs, and targeted stock offerings between 1990 and 1995. We find that, after these transactions, sample firms experience a significant increase in coverage by analysts that specialize in subsidiary firms’ industries, and a 30–50% increase in analyst forecast accuracy for parent and subsidiary firms. The improvement in forecast accuracy is partially attributable to expanded disclosure. However, forecast improvements for specialists exceed those for non‐specialists, leading us to conclude that corporate focus can facilitate improved capital market intermediation by financial analysts with industry expertise.

This paper investigates the value relevance of historical cost, price level and replacement cost accounting using a sample of Mexican firms from 1989 to 1995. It contributes to prior research by distinguishing between two distinct aspects of changing prices:(1) the change in the general price level, and (2) the change in the value of specific non‐monetary assets. I select Mexico to examine because it is unique in requiring and disclosing separately price level and replacement cost adjustments. A sample of Mexican firms also addresses a key reason cited for mixed results in previous assessments of the usefulness of price level and replacement cost accounting using United States data: the effects of inflation are too weak to detect. High rates of inflation in Mexico, ranging between 7% and 52% during the sample period, mitigate that potential problem. Results indicate that replacement cost adjustments are relatively and incrementally relevant beyond historical cost and price level measures while price level adjustments are incrementally value relevant beyond historical measures.

This paper examines the association between external monitoring and earnings management by property‐casualty insurers. We extend previous work by Petroni and Beasley (1996) by expanding the set of external monitors to include both auditors and actuaries. We investigate whether certain auditor‐actuary pairs are associated with less understatement of the loss reserve account by financially struggling insurers. Our data consist of loss adjustments reported by 465 property‐casualty insurers for reserves established in 1993. The results indicate that under‐reserving by weak insurers is essentially eliminated when the firm uses auditors and actuaries that are both from Big Six accounting firms. In contrast, non‐Big Six actuaries have less impact on under‐reserving by weak insurers. Our results suggest that the quality usually associated with Big Six auditors falls when the audit firm relies on third party actuaries to evaluate the loss reserve estimates of struggling insurance clients. We conjecture that Big Six actuaries insist on more conservative loss reserve levels because, compared to actuarial consulting firms, they are more attuned to the liability exposure of the auditor.

We show analytically that mean analyst forecasts inefficiently aggregate information by assigning too much weight to analysts’ common information relative to their private information when used as a summary forecast measure of forthcoming earnings. A more precise summary forecast of earnings than the current mean forecast is the current mean forecast plus a positive multiple of the change in the mean forecast.

This study analyzes the relation between auditors' perceived business risk and audit fees to determine whether audit firms or their clients bear the expected legal costs of business risk. We predict that hourly audit fees and the number of audit hours are increasing in business risk. Using confidential survey data collected by a large international accounting firm for 422 audits, we find that high business risk increases the number of audit hours, but not the fee per hour. This implies that firms perceive firm‐level differences in business risk and obtain compensation through billing additional hours, not by raising the hourly charge.

This paper analyzes a communication game between a sender and receiver with misaligned incentives. Because of the misalignment, in equilibrium, the sender's privately observed information is not perfectly communicated. We study the relation between the quality of the sender's information and the quality of the information communicated. We establish that the quality of information communicated is a non‐monotonic function of the quality of the sender's information, and it is maximized when the sender has imperfect information. We suggest that our model applies to a setting where an equity research analyst communicates information about a firm's value to investors.

We investigate potential management of balance sheet ratios by a sample of firms that reclassify short‐term obligations to long‐term debt and subsequently declassify that debt (return it to the current liability section). Although aggregate measures of liabilities and equity remain unchanged when firms reclassify (declassify), the practice does increase (decrease) reported measures of liquidity, such as the current ratio, and long‐term leverage. Our results suggest that firms reclassify and declassify to smooth reported liquidity and leverage, relative to the prior year and to industry benchmarks. Our evidence is also consistent with firms working around restrictive debt covenants.