Knowledge that Transforms

Numerous proxies for divergence of investors' opinions have been suggested in the empirical accounting and finance literatures. I offer a new proxy constructed from proprietary limit order and market order data. This allows me to capture additional information on investors' private valuations. Proxies from the extant literature, based on publicly available data, do not contain such information. Given my new measure, I ask which of the extant proxies correlates best with it. In my regression analysis, unexplained volume is the best proxy for opinion divergence. Conditioning on various firm‐specific and order‐specific characteristics generally does not change this conclusion. The main exception is the sample of firms without IBES forecast dispersion data, for which bid‐ask spread is the best proxy for opinion divergence. Factor analysis also suggests that unexplained volume is the preferred proxy for opinion divergence.

In this paper we examine how accounting conservatism affects the efficiency of debt contracting. We develop the statistical and informational properties of accounting reports under varying degrees of conditional and unconditional accounting conservatism, consistent with Basu's [1997] description of differential verifiability standards. Optimal debt covenants and interest rates on debt are derived from a natural tension between debt holders and equity claimants. We show how optimal covenants vary with the degree of conservatism and derive an efficiency metric that depends on the degree of conservatism. We find that accounting conservatism actually decreases the efficiency of debt contracts, contrary to the suggestions of Watts [2003] and contrary to the hypothesis in numerous empirical studies.

This study uses a large sample of sell‐side bond analysts' reports to examine the properties of recommendations provided by bond analysts and the impact of these recommendations on bond securities. First, we document that the distribution of bond analysts' buy, hold, and sell recommendations is skewed positively, but less so than the distribution of equity analysts' recommendations. The positive skewness in bond analysts' recommendations is greater for low than for high credit quality bonds. Second, we find that bond analysts' reports generate bond trading and return reactions that are both economically significant and greater for low credit quality bonds. The bond market reaction is greater for bond analysts' reports than for equity analysts' reports. Finally, while both bond and equity analysts lead rating agency announcements, we find no evidence of a difference in timeliness between bond and equity analysts' reports. Overall, our results are consistent with bond analysts issuing more negative reports than equity analysts and providing more information about low credit quality bonds as a result of the asymmetric demand for negative information by bond investors.

In December 2004, the Financial Accounting Standards Board (FASB) mandated the use of a fair value–based measurement attribute to value employee stock options (ESOs) via Financial Accounting Standard (FAS) 123‐R. In anticipation of FAS 123‐R, between March 2004 and November 2005, several firms accelerate the vesting of ESOs to avoid recognizing existing unvested ESO grants at fair value in future financial statements. We find that the likelihood of accelerated vesting is higher if (1) acceleration has a greater effect on future ESO compensation expense, especially related to underwater options, and (2) firms suffer greater agency problems, proxied by fewer blockholders, lower pension fund ownership, and top five officers holding a greater share of ESOs. We also find a negative stock price reaction around the announcement of the acceleration decision. Furthermore, stock returns are significantly negative before the new vesting dates and positive afterward, suggesting that vesting dates could have been backdated.

The U.S. system of securities law was designed more than 70 years ago to regain investors' trust after a major financial crisis. Today we face a similar problem. But while in the 1930s the prevailing perception was that investors had been defrauded by offerings of dubious quality securities, in the new millennium, investors' perception is that they have been defrauded by managers who are not accountable to anyone. For this reason, I propose a series of reforms that center around corporate governance, while shifting the focus from the protection of unsophisticated investors in the purchasing of new securities issues to the investment in mutual funds, pension funds, and other forms of asset management.

The reported cost of a product frequently contains historical cost components that reflect past investments in productive capacity. We examine a setting wherein a firm makes a sequence of overlapping capacity investments. Earlier research has identified particular accrual accounting (depreciation) rules with the property that, on a per unit basis, the historical cost of a product captures precisely its marginal cost. Relative to this benchmark, we investigate and characterize the direction and magnitude of the bias in reported historical cost that results from alternative depreciation rules, including in particular straight‐line depreciation in conjunction with partial direct expensing. In addition, we demonstrate that for a reasonable range of parameter specifications the resulting bias is rather small. Finally, we apply our framework to two specific settings. First, in a regulatory context, we establish the extent to which the accounting profit margin is indicative of a firm's pricing power in the product market. Second, we model an internal control scenario in which a manager's performance is evaluated using residual income, and identify the distortions in investment levels that result from the use of alternative depreciation rules.

The Sarbanes‐Oxley Act (SOX) mandates management evaluation and independent audits of internal control effectiveness. The mandate is costly to firms but may yield benefits through lower information risk that translates into lower cost of equity. We use unaudited pre–SOX 404 disclosures and SOX 404 audit opinions to assess how changes in internal control quality affect firm risk and cost of equity. After controlling for other risk factors, we find that firms with internal control deficiencies have significantly higher idiosyncratic risk, systematic risk, and cost of equity. Our change analyses document that auditor‐confirmed changes in internal control effectiveness (including remediation of previously disclosed internal control deficiencies) are followed by significant changes in the cost of equity that range from 50 to 150 basis points. Overall, our cross‐sectional and intertemporal change test results are consistent with internal control reports affecting investors' risk assessments and firms' cost of equity.

We merge portfolio theories of home bias with corporate finance theories of insider ownership to create the optimal corporate ownership theory of the home bias. The theory has two components: (1) foreign portfolio investors exhibit a large home bias against countries with poor governance because their investment is limited by high optimal ownership by insiders (the “direct effect” of poor governance) and domestic monitoring shareholders (the “indirect effect”) in response to the governance and (2) foreign direct investors from “good governance” countries have a comparative advantage as insider monitors in “poor governance” countries, so that the relative importance of foreign direct investment is negatively related to the quality of governance. Using both country‐level data on U.S. investors' foreign investment allocations and Korean firm‐level data, we find empirical evidence supporting our optimal corporate ownership theory of the home bias.

We evaluate the impact of the Sarbanes‐Oxley Act (SOX) on shareholders by studying the lobbying behavior of investors and corporate insiders in order to affect the final implemented rules under SOX. Investors lobbied overwhelmingly in favor of strict implementation of SOX, while corporate insiders and business groups lobbied against strict implementation. We identify firms most affected by the law as those whose insiders lobbied against strict implementation. Such firms appear to be characterized by agency problems, rather than motivated by concerns over compliance costs. Cumulative stock returns during the five and a half months leading up to SOX passage were approximately 7% higher for corporations whose insiders lobbied against SOX disclosure‐related provisions than for similar non‐lobbying firms, consistent with an expectation that SOX would reduce agency problems. Analysis of returns in the post‐passage implementation period suggests that investors' positive expectations with regards to the effects of these provisions were warranted.

This paper examines whether a country's corporate transparency environment, which includes the quality of accounting information, contributes to efficient resource allocation. Based on a cross‐country study of 37 manufacturing industries in 37 countries, we provide three pieces of related evidence. First, we find the contemporaneous correlations in industry growth rates across country pairs are higher when there is a greater level of corporate transparency in the country pairs, after controlling for country‐level economic and financial development. Second, we find the influence of transparency on these correlations is stronger when country pairs are at similar levels of economic development (GDP). Finally, when we control for the level of transparency explained by a country's institutions in place, we find that residual transparency (unexplained by country‐level factors) is associated with industry‐specific growth rates. Taken together, the results are consistent with corporate transparency facilitating the allocation of resources across industry sectors.