Knowledge that Transforms

We investigate whether acquiring firms attempt to increase their stock price prior to a stock for stock merger in order to reduce the cost of buying the target. In a sample of stock for stock mergers completed between 1985 and 1990, we find that acquiring firms manage earnings upward in the periods prior to the merger agreement. Our results also indicate that the degree of income increasing earnings management is positively related to the relative size of the merger.

We predict and find that firms use annual grants of options and restricted stock to CEOs to manage the optimal level of equity incentives. We model optimal equity incentive levels for CEOs, and use the residuals from this model to measure deviations between CEOs’ holdings of equity incentives and optimal levels. We find that grants of new incentives from options and restricted stock are negatively related to these deviations. Overall, our evidence suggests that firms set optimal equity incentive levels and grant new equity incentives in a manner that is consistent with economic theory.

Prior studies have identified systematic and time persistent differences in analysts’ earnings forecast accuracy, but have not explained why the differences exist. Using the I/B/E/S Detail History database, this study finds that forecast accuracy is positively associated with analysts’ experience (a surrogate for analyst ability and skill) and employer size (a surrogate for resources available), and negatively associated with the number of firms and industries followed by the analyst (measures of task complexity). The results suggest that analysts’ characteristics may be useful in predicting differences in forecasting performance, and that market expectations studies may be improved by modeling these characteristics.

Relative performance evaluation (RPE) is likely to improve boards of director's ability to identify unfit CEOs, and competition is likely to enhance the usefulness of RPE. Consistent with our hypotheses, the frequency of CEO turnover is greater in highly competitive industries than in less competitive industries. We also find that RPE-based (firm-specific) accounting measures are more closely associated with CEO turnover in high (low) competition industries than in low (high) competition industries. These findings suggest that the lack of support for RPE in prior studies results from not considering the effects of competition.

We investigate the market valuation of earnings and book value amounts prepared under IAS and US-GAAP to provide evidence for the debate between the US SEC and NYSE on whether foreign firms should be allowed to list in the US using IAS. We find that the US-GAAP earnings reconciliation adjustment is value-relevant and that US-GAAP amounts are valued differently for market value and return models, but not a price-per-share model. We also find that IAS amounts are more highly associated with price-per-share than US-GAAP amounts, and that US-GAAP amounts are more highly associated with security returns than IAS amounts.

This paper adapts Dye's (1995) model to evaluate the effects of the 150-hour rule on the audit market. Incorporating the auditors’ education as a joint input with the audit effort for determining the audit quality, we show that the audit fee is higher, pre-rule CPAs are better off, and audit clients are worse off as results of the Rule. Additionally, more pre-rule CPAs elect to enter the audit market. Some less wealthy post-rule CPAs who would otherwise get into the audit market choose not to. Surprisingly, the average audit quality in the market can be lower due to the Rule.

We use a rational expectations model to examine how public disclosure requirements affect listing decisions by rent-seeking corporate insiders, and allocation decisions by liquidity traders seeking to minimize trading costs. We find that exchanges competing for trading volume engage in a ‘race for the top’ whereunder disclosure requirements increase and trading costs fall. This result is robust to diversification incentives of risk-averse liquidity traders, institutional impediments that restrict the flow of liquidity, and listing costs. Under certain conditions, unrestricted liquidity flows to low disclosure exchanges. The consequences of cross-listing also are modeled.

This study examines UK firms' contracting cost incentives for capitalizing estimates of brand value. Results indicate that firms' decisions to capitalize acquired brands were influenced by the impact that the immediate write-off of goodwill to equity has on the London Stock Exchange's shareholder approval requirement for future acquisitions and disposals. These findings provide evidence of contracting costs that result from stock exchange mandated shareholder approval rules for planned transactions.

The papers by Muller and ABK (Aboody, Barth and Kasznik) provide evidence on the reliability of estimates of assets' `current' or `market' values. Muller finds that the decision to capitalize estimates of acquired brand values is influenced by contracting incentives, suggesting that the reliability of these estimates is compromised by managerial manipulation. ABK find that estimates of fixed asset revaluations have a statistically significant association with both contemporaneous stock prices and future operating performance. It is difficult to assess the implications of ABK's results for the reliability of the revaluations, because stock prices and operating performance are influenced by many other factors.

We investigate the relation between CEO compensation and accounting performance measures as a function of ownership structure. We use publicly-held property-liability insurers to consider the relation for firms with diffusely-held ownership and use privately-held property-liability insurers to consider the relation for firms with closely-held ownership. We find a significant positive association between return on assets and the level of compensation for publicly-held insurers. Consistent with optimal contracting theory, we find no such relationship for privately-held insurers. Results suggest that within closely-held firms CEO compensation is less based on objective measures like accounting information and more on subjective measures.