Knowledge that Transforms

[This study examines the motivation of managers to release forecasts of future earnings. Four potential motivating factors were compared for a sample of firms that reported forecasts and another sample of firms that did not release this information. The four factors are: (1) reporting good news, (2) correcting or confirming analysts' forecasts, (3) new capital offerings, and (4) ownership structure. A manager's forecast released when analysts have underestimated earnings implies good news. The relative importance of the correction or confirmation of analysts' forecasts was tested by examining the absolute errors of analysts' forecasts. Larger absolute errors of analysts' forecasts for reporting firms than for other firms imply that managers' forecasts could be correcting forecasts. Otherwise, they are confirming forecasts. The literature also suggests that some managers release forecasts prior to issuing new capital. This hypothesis was tested by examining the occurrences of new capital offerings for the reporting and comparison firms. Differences in ownership structure represent a fourth factor potentially associated with the release of forecasts. Prior literature suggests that the release of forecasts when outside holdings are relatively high can help reduce agency costs. The association of ownership structure with the release of forecasts was tested by examining the percentage of inside ownership for the reporting and comparison firms. Multivariate tests show that ownership structure, absolute errors of analysts' forecasts, and new capital offerings are significant. Absolute errors of analysts' forecasts are smaller for the forecast reporting firms than for the comparison firms, suggesting that managers' forecasts are, on average, confirmatory. The results also reveal that new capital is more likely to be issued subsequent to the date of the forecast (or equivalent date) by the reporting firms than by the comparison firms. However, the evidence is not consistent with the assumption that managers release good-news forecasts. Additional joint tests were conducted using data for the years before and after the forecast release. These tests show that absolute analysts' forecast errors and capital offerings are not significant factors for the years before or after the forecast release, suggesting that these factors reflect the motivation of managers to release earnings forecasts.]

[This article describes a model in which an endogenous demand for cost reports exists, and characterizes optimal contracts. A principal employs an agent to implement investment projects. The agent's payments are subject to bankruptcy constraints; that is, the agent's wealth cannot fall below zero. To achieve the cost report perspective, the agent is assumed to acquire and communicate his/her private information after investment and production. The principal usefully incorporates the agent's cost reports within an optimal contract, in spite of two constraining features. First, the agent's information is only about historical costs, which are not informative about future investment opportunities. Second, at no time can the principal verify the agent's cost reports. However, as a substitute for cost verification in our model, the principal and agent can write long-term contracts. Although an unverifiable report is not useful in a one-period setting, in two periods it may become useful. We demonstrate necessary conditions for communication to be valuable in two periods. If single period contracts are used, the principal's residual claim is sometimes less than it would be in a full information setting. This loss occurs if and only if the bankruptcy constraints are binding in one period; that is, they prevent the principal from efficiently selling the firm to the risk-neutral agent. The principal's optimal reaction, given the tightness of the bankruptcy constraints, is either to underinvest or to permit the agent to keep any informational rents. Long-term contracts loosen the bankruptcy constraints because they permit the agent to accumulate wealth. We identify costs and benefits of communication-based two period contracts. Through long-term contracts, the principal makes a tradeoff: he commits to ex post inefficient investment decisions in order to reduce the cost of obtaining truthful reports from the agent. In some cases, production increases, leading to larger cash distributions to both parties. In other cases, production decreases, but the principal's residual increases because the agent's informational rents are reduced.]

[This paper compares the disclosures firms would seek to make voluntarily with "optimal" mandated disclosures in a single period, multi-firm model, in which there are covariances between firms' cash flows. This comparison is important because, in those circumstances in which the two types of disclosure coincide, it is possible to economize on the process of setting mandatory disclosures. The principal factors which contribute to the existence or absence of a correspondence between mandatory and voluntary disclosures are (1) the nature of the externality associated with a firm's disclosure, (2) the relation between the risk preferences of the shareholders of the firms making the disclosures and outside investors, (3) how much relative weight is placed on existing shareholders and outside investors' preferences in the social welfare function determining the optimal mandatory disclosure policy, and (4) the covariance structure between firms' cash flows.]

[This study reports on two experiments examining the effects of alternative incentive pay schemes for controlling unit manager behavior in intrafirm resource allocation settings. Two control problems are addressed: unit managers' misrepresentation of private information to the central manager prior to allocation, and unit managers' consumption rather than investment of resources subsequent to allocation. The experimental setting was adapted from Groves and Loeb (1979). The firm consists of central management and two units. The role of the (mechanized) central manager is to maximize firm profit by acquiring a common resource and allocating it to the units. The central manager also executes a control mechanism consisting of a performance measure and pay function for the unit managers. The role of each unit manager is to send a message to the central manager before the resource is acquired and to generate profit by investing allocated resources in productive activities. Actual unit profit depends on the unit's profit function and invested resources, which are known only to the unit manager. The linear profit function was in the form of a productivity ratio, i.e., the ratio of outputs to inputs. The central manager learns each unit's actual profit when realized. In both experiments, students served as subjects. Experiment 1 focused on unit managers' misrepresentation, which was measured by the difference between projected and actual p-ratios, under three incentive schemes: (1) unit profit scheme-a unit manager's pay is linear in actual unit profit, (2) unit profit-plus-penalty scheme-a unit manager's pay is linear in actual unit profit except that there is a "large" penalty when an unfavorable profit variance occurs, and (3) Groves scheme-a unit manager's pay is linear in the sum of his or her unit's actual profit and the other unit's budgeted profit. As predicted, misrepresentation was higher under the unit profit scheme than under the other schemes. Contrary to prediction, misrepresentation was higher under the Groves scheme than under the unit profit-plus-penalty scheme. The latter result may have been due to either or both of two factors associated with the Groves scheme. First, some subjects may have tried to gain from tacit collusion. Second, some subjects may have failed to understand the scheme's incentives, given noncooperation. Experiment 2 focused on resource consumption, which was measured by inputs exchanged directly for cash rather than invested, under the Groves and unit profit-plus-penalty schemes. As predicted, resource consumption was higher under the Groves scheme than under the unit profit-plus-penalty scheme. This result was largely due to the latter scheme's penalty, which forces a unit manager to invest enough resources to achieve budgeted unit profit.]

[Recent research indicates that auditors' account value estimates from analytical review are affected by knowledge of the unaudited account value (or book value). The exact nature of the consequences from the auditor's use of book value for analytical review has not been formally shown and is a source of controversy. This paper examines the audit cost and risk consequences associated with the auditor's reliance on book value for analytical review. The analysis is framed within a Bayesian decision theoretic model and is conducted for a comprehensive set of audit and environmental conditions. The results include expressions for audit cost/risk when the auditor's analytical review is and is not conditioned on book value. While definitive inferences are possible only when certain intuitive criteria are used, the advantages of incorporating book value in the practice of analytical review appear minimal. That is, reliance on book value would seem to require a procedure that, if reliable, would preclude the need for analytical review (or any other audit procedures).]

[Numerous researchers have conducted empirical analyses of market reactions to information announcements using trading volume (e.g., Kiger 1972; Morse 1980, 1981; Bamber 1986, 1987; Ziebart 1987) since Beaver (1968) investigated both price and volume reactions to earnings announcements. Beaver contended that abnormal trading volume reflects the degree to which the individual investors in the market revise their expectations as a result of the announcement whereas abnormal returns reflect the aggregate revision in expectations. In Beaver's framework, volume reactions reflect a lack of consensus among the market participants and capture changes in portfolio positions that may not be manifested in price changes. However, a number of other factors such as cash flow coordination, changes in risk preferences, changes in portfolio risk, or taxation may be driving trading activity. Unfortunately, the appropriate economic interpretation to place on an observed trading volume reaction to an information announcement has not been determined. A number of analytical studies have attempted to explain trading volume and belief structures, and in so doing provide a framework for interpreting trading reactions (e.g., Verrecchia 1981; Hakansson et al. 1982, 1984; and others). The results of these studies are mixed, and depending on the formulation of the analysis, a link between consensus of beliefs and trading volume is either demonstrated or dismissed. Given these mixed results, an empirical assessment of the extent to which trading volume reflects changes in consensus is warranted. For a sample of 611 earnings announcements of 90 NYSE-listed firms, this study empirically investigates the association between changes in the level of consensus of beliefs in the market, proxied by the dispersion in analysts' forecasts of annual earnings per share, and changes in the abnormal weekly trading activity surrounding corporate earnings announcements. In addition, changes in abnormal trading volume are also hypothesized to be a positive function of the change in the aggregate belief, proxied by the absolute value of the change in the mean of the analysts' forecasts. An inverse relation between the level of predisclosure information, proxied by firm size, is also expected. The results of this study support the hypothesis that the degree of change in abnormal trading activity is positively associated with both the change in the level of consensus and the absolute value of the percentage revision in the analysts' mean forecast. The evidence does not support the hypothesized link between the change in abnormal trading activity and the level of predisclosure information. These results suggest that an observed trading volume reaction reflects both the revision of beliefs in aggregate, reflecting the "surprise" in the earnings announcement, and the consensus of the individuals' revisions. Unfortunately, the low explanatory power of the variables included in this study suggests that an observed trading volume reaction may reflect the effects of a number of other factors not included in this study.]

[Financial information about an organization is normally more accessible to management than to union negotiators. This article deals with the effects of disclosure of this information to union negotiators on the resolution of industrial conflict. This study differs from previous research in that it (1) defines information symmetry as pre-negotiation knowledge of financial information about the entity in which both negotiators have interests, rather than as direct knowledge of the opponents' payoff, (2) is conducted in a union-management bargaining context, and (3) is concerned with both settlements and conflicts. As conditions of information symmetry would be difficult to operationalize and control in the field, a laboratory experiment was used to examine the effects of financial information disclosure (symmetry vs. asymmetry) under two conditions of profitability (profit vs. loss) on pre-negotiation expectations and perceptions, and on negotiation outcomes (settlements and conflicts). In the experiment, a negotiating dyad was formed by assigning one subject a management role and another a union role. In all, 80 subjects forming 40 negotiating dyads participated in the experiment. Profitability took two levels: a profit case or a loss case. Disclosure was manipulated by either providing or withholding historical and forecast financial information to union subjects. A pre-negotiation questionnaire solicited perceptions and expectations of subjects. If subjects did not reach a negotiated settlement, their final impasse offers were submitted for arbitration to a hypothetical arbitrator. A post-negotiation questionnaire was then used to obtain subjects' evaluations and perceptions regarding the company, information, settlement, and opponent. Subjects were rewarded according to the level of negotiated or arbitrated settlement. The results of the experiment generally showed that union subjects' pre-negotiation expectations and conflicts were consistently higher when information was not disclosed to them than in the symmetry case, but expectation differences were statistically significant only in the loss case. As expected, settlements were generally higher in the profit case than in the loss case. Insignificant differences were obtained in post-negotiation conflicts and settlements between the asymmetry and symmetry treatments, possibly for two reasons. First, indirect disclosures by management subjects during negotiation may have been made. Second, as negotiating parties in the symmetry or asymmetry treatments reached an impasse, they may have moved farther apart in anticipation of an arbitrated settlement. As settlements and post-negotiation conflicts seemed unaffected by disclosure, an implication of the findings is that unions might benefit by investigating the decision value of the financial information they seek, while management need not automatically assume that information disclosure would make it worse off.]

[The property-liability (P&L) insurance industry has used statutory accounting principles (SAP) primarily for measuring and monitoring solvency. In recent years disputes have arisen concerning differences between SAP and the Generally Accepted Accounting Principles (GAAP), and their applications to the P&L industry. The distinguishing characteristics of SAP include the use of market prices for valuation of equity portfolios of P&L firms, and the mismatching of revenues and expenses. The present study compares SAP with GAAP and with an alternative accounting procedure that might be called market value- and cash-flow-based principles (MVA). The main characteristics of MVA are the use of market data for valuation of both stock and bond portfolios, and the use of cash flow for earnings. The purpose of this study is to determine which of the three accounting procedures provides better information for monitoring solvency and identifying financial distress. Thus, the major hypothesis of this study is that increased availability of market-based data and increased reliance on cash-flow figures yield incremental benefits in predicting financial insolvency in the P&L industry. Some empirical evidence with respect to the relative efficacy of SAP has been reported for the late 1960s and the 1970s. These earlier studies used multidiscriminant analysis (MDA) and suffered from some methodological problems. The present study extends previous analyses by using relatively more comprehensive accounting data in logit analysis. A sample of 105 P&L companies that failed during the period 1975-1987 is used in this study. The insolvent insurers were matched with 106 P&L insurers selected at random from A. M. Best files. The solvent and insolvent samples were each split into an estimation sample and a holdout sample. The results of this study are reported for one and three years prior to insolvency. Univariate analysis and multivariate logit analyses are presented. The hypothesis that alternative accounting procedures provide similar classification results was rejected in this paper for both the estimation and holdout samples and for the one and three years prior to the onset of insolvency. The analyses also considered misclassification costs, prior probabilities, and choice-based sample biases; both MVA and SAP procedures outperformed GAAP procedures for all classification and prediction (validation) comparisons. MVA slightly dominated SAP procedures for several comparisons of classification and prediction, but the differences were often not significant. Thus, empirical evidence presented suggests that the SAP and the MVA provide classification and prediction of insolvencies in the P&L insurance industry over and above that provided by the GAAP.]

[This paper presents a partially revealing rational expectations model of competitive trading to identify two effects of information releases; an informedness effect and a consensus effect. The informedness effect measures the extent to which agents become more knowledgeable, and the consensus effect measures the extent of agreement among agents at the time of an information release. We demonstrate that informedness and consensus generally occur jointly when information is disseminated, and that unexpected price changes and trading volume are each influenced by both informedness and consensus. Thus, interpretations of unexpected price changes and volume associated with information releases are conceptually similar. Since informedness and consensus each affect both the variance of price changes and volume, our paper provides an economic rationale for examining both price and volume effects at the time of information releases.]

[Management accountants are often required to construct measures of performance of individual managers by aggregating several accounting numbers (signals). We show that the same method of aggregation will rarely be used for evaluating the performance of different managers. Instead, the method of aggregation will vary with the specific preference functions of individual managers and the corresponding action choices induced by the owner. Such an optimal aggregate always exists but is not, in general, a sufficient statistic for the individual signals with respect to the agent's effort. We further show that, in most cases, using all the information in the sufficient statistic makes the principal strictly worse off. The analysis provides insights into a different statistical approach for evaluating nonsufficient aggregates based on the signal to noise ratio of the individual signals that are aggregated.]