Knowledge that Transforms

We provide an informational theory for how the ownership claims to a firm might be structured. When the market price of equity provides valuable contracting information there is a benefit to creating separate ownership claims to each of a firm's divisions. However, creating this information also generally has adverse incentive effects because it enriches the agent's strategy space. We show in a complete contracting setting that under a large class of agencies the firm is strictly better off bundling the ownership claims to divisions that are sufficiently similar and creating separate ownership claims only to divisions that are sufficiently different.

This paper studies a competitive asset market characterized by an adverse selection problem. The analysis focuses on the link between the market participants’ productive activities and discretionary disclosures. While informed parties’ discretion over disclosure allows them to earn private gains, it leads to an inefficient allocation of resources. A more informative signal makes the informed parties better off, but reduces the uninformed parties’ welfare. Nonetheless, it improves the economy's allocative efficiency. The paper also shows that when the signal quality is endogenous, the informed parties over-invest in the signal informativeness relative to the level that maximizes social welfare.

Two ingredients necessary to examine the relation between litigation risk and audit pricing are (a) a litigious legal environment, and (b) publicly disclosed auditor remuneration. We combine both ingredients by focusing on UK firms offering to sell their securities publicly in the United States. We find that UK auditors charge higher fees for their services when their clients access US, but not non-US, capital markets. Further, we show that the higher fees cannot be fully explained by the SEC's extensive disclosure requirements. Rather, these findings are consistent with audit fees reflecting risk differences across liability regimes.

This study investigates whether fee dependence within the audit firms’ offices jeopardises auditor independence. Fee dependence is examined at both the national audit firm level as well as the local office level and in a setting where public disclosure of fees is mandatory. We focus our tests on audit fee dependence and at the same time we control for the effects of non-audit service fee dependence post the 1989 mergers. We operationalise the exercise of independent judgement in auditing by the propensity to issue qualified audit opinions. If fee dependence affects auditors’ independent judgement, then auditors are less likely to qualify the accounts. The study's results show that the level of auditor fee dependence does not affect auditor propensity to issue unqualified audit opinions. The findings remain robust to a number of sensitivity tests including the analyses controlling for the effects of non-audit service fee dependence and other settings in which there is heightened pressure on auditors to confront the effects of fee dependence on exercising independent audit judgement.

This study examines the equity price reaction to the pronouncements related to accounting for stock-based compensation and assesses the value relevance of recognition versus disclosure in financial reporting. We document that firms exhibit significant abnormal returns around the issuance of the Exposure Drafts proposing to require recognition of stock-based compensation costs, and also around the event reversing that decision to require disclosure only (while encouraging recognition). We also document that the abnormal returns are most pronounced for high-tech, high-growth, and start-up firms. Our results are consistent with the contracting theory, and show that disclosure is not a substitute for recognition.

We investigate whether competing information, primarily analyst reports, reduces the usefulness of earnings announcements. Inconsistent with the view that information in analyst reports substitutes for earnings announcements, we find a positive relation between absolute abnormal returns to the two types of disclosures. This positive relation also characterizes subsequent period analyst reports relative to current period earnings announcements. We also find that aggregate absolute reactions to both types of disclosures increased over 1986–1995. As a whole, these results provide little support for the view that the informativeness of earnings announcements is eroded by competing information in the form of analyst reports.

This paper finds that firms that meet or beat current analysts’ earnings expectations (MBE) enjoy a higher return over the quarter than firms with similar quarterly earnings forecast errors that fail to meet these expectations. Further, such a premium to MBE, although somewhat smaller, exists in the cases where MBE is likely to have been achieved through earnings or expectations management. The findings also indicate that the premium to MBE is a leading indicator of future performance. This premium and its predictive ability are only marginally affected by whether the MBE is genuine or the result of earnings or expectations management.

We employ a certainty-equivalence framework to analyze the cost, value and pay/performance sensitivity of non-tradable options held by undiversified, risk-averse executives. We derive “executive value” lines, the risk-adjusted analogues to Black–Scholes lines. We show that distinguishing between “executive value” and “company cost” provides insight into many issues regarding stock option practice including: executive views about Black–Scholes values; tradeoffs between options, restricted stock and cash; exercise price policies; option repricings; early exercise policies and decisions; and the length of vesting periods. It also leads to reinterpretations of both cross-sectional facts and longitudinal trends in the level of executive compensation.

In this paper, we examine how the exclusion of voluntary and mandatory accounting changes from the calculation of covenant compliance affects the interest rate charged on the loan. After controlling for self-selection bias and other factors known to affect loan spreads, we find that the rate charged is 84 basis points lower when voluntary accounting changes are excluded and 71 basis points lower when mandatory accounting changes are excluded. Our results suggest that borrowers are willing to pay substantially higher interest rates to retain accounting flexibility that may help them avoid covenant violations and to avoid duplicate record-keeping costs.