Knowledge that Transforms

At the heart of decentralization lies the notion that tasks are delegated by owners to managers who possess superior local information. The extent of this information asymmetry is often an endogenous construct, as it is influenced by the owner's choice of internal accounting systems and the manager's investment in acquiring local expertise. In this paper, we explore how varying levels of pre-contract, asymmetric information affect the owner-manager relationship. We provide three main sets of insights. First, we find that the owner's payoffs are initially decreasing, and strictly convex everywhere, in the quality of the manager's private information. The owner thus prefers to deal with either a perfectly informed or a perfectly uninformed manager, and we characterize conditions for either to be the preferred choice. Second, in contrast to recent work, we demonstrate that when information can be communicated internally, the optimal strength of managerial incentives unambiguously decreases as the manager becomes better informed. Third, we derive the surprising result that a self-interested manager does not always prefer to maximize his informational advantage. Our work has implications for the optimal design of organizations, and for internal accounting and control systems in particular.

Recent research provides evidence that the operating cash flows-to-price ratio subsumes accruals in explaining future annual returns. This suggests that the accrual anomaly is part of the overall value-glamour anomaly and does not represent the mispricing of earnings. We extend the literature by using multiple measures of abnormal accruals and separate analyses of future annual returns and future earnings announcement returns. The results reveal that the operating cash flows-to-price ratio does not subsume abnormal accruals in explaining future annual returns or future announcement returns. We also find that the operating cash flows-to-price ratio does not subsume total accruals in explaining future announcement returns. These results are not consistent with accruals being a manifestation of the value-glamour anomaly. Our study contributes to the current debate on the existence and the extent of the (abnormal) accrual anomaly. Moreover, the methodology employed can help researchers in exploring mispricing phenomena.

Despite the classification of the cash flows on trading positions as operating under SFAS No. 102, trading is economically a hybrid operating/non-operating activity. Reflecting this hybrid nature, we hypothesize and find that the change in net trading assets has a less positive association with returns and future CFO than do the pure operating components of cash flows and accruals, and it has a more positive association with returns and future CFO than do the pure non-operating components of cash flows. Our paper is the first to propose and test hypotheses about the valuation implications of such hybrid cash flows and accruals.

This study examines how the form of management's earnings guidance (point, narrow range, wide range) affects analysts' earnings forecasts. Results from two experiments demonstrate that: (1) guidance form has no effect on analysts' forecasts made immediately after the guidance; and (2) after the actual earnings announcement, guidance form and the relationship of the earnings guidance to actual earnings (guidance error) interact in their effect on analysts' forecasts. After the actual earnings announcement, guidance error leads to higher (lower) analysts' forecasts for firms with downwardly (upwardly) biased guidance; this effect of guidance error is magnified by a narrow range and reduced by a wide range, compared to a point estimate. These results suggest that treating the mean of the range endpoints as equivalent to a point estimate and failing to consider effects after the release of actual earnings may paint an incomplete picture of how management guidance affects analysts and investors. It also offers useful information to managers who issue earnings guidance, and presents a challenge to the psychology literature regarding the effects of information precision on judgment and decision making.

The recent spate of fraudulent financial reporting in the U.S. has drawn attention to the fact that the Chief Financial Officer (CFO) has a substantial amount of control over a firm's reported financial results. This paper examines the changes in discretionary accruals surrounding the appointment of a new CFO. Using a sample of 712 companies that appointed a new CFO in the period 1994 to 2000, we find that discretionary accruals decreased significantly following the appointment of a new CFO. Our tests indicate that this reduction is significantly greater for our group of CFO-hiring firms than for a control group of non-hiring firms, and that the changes are not driven by a concurrent appointment of a new Chief Executive Officer (CEO). We also find that our results are largely driven by firms that hire a new CFO from outside the company. Our study extends earlier research by providing empirical evidence that individuals in CFO positions wield significant influence over the firm's reported financial results and that a firm's discretionary accruals are significantly reduced surrounding the appointment of a new CFO.

Prior research indicates that greater transparency in reporting formats facilitates the detection of earnings management. The current study hypothesizes and demonstrates that greater transparency in comprehensive income reporting also reduces the likelihood that managers will engage in earnings management in the area of increased transparency. In our experiment, 62 financial executives and chief executive officers decide which available-for-sale security to sell from a portfolio. We manipulate the transparency of comprehensive income reporting and the relationship of projected earnings to the consensus forecast in a 2×2 between-subjects design. When projected earnings are below (above) the consensus forecast, participants sell securities that increase (decrease) earnings. However, the rarely used, more transparent format for reporting comprehensive income significantly reduces both income-increasing and income-decreasing earnings management. Participants in the less transparent setting indicate that earnings management attempts will not be obvious to readers, will improve stock prices, and have no effect on management's reputation for reporting integrity. Conversely, respondents in the more transparent condition suggest that earnings management will be obvious to readers, harmful to stock prices, and damaging to reporting reputation. Results of this study suggest that more transparent reporting requirements will reduce earnings management in the area of increased transparency or change the focus of earnings management to less visible methods.

We examine the impact on share prices of firms whose CEOs and CFOs certify their financial statements under oath, pursuant to the administrative order issued by the SEC on June 27, 2002. We hypothesize that (1) the certification provides assurance to investors by making disclosure more credible and by reducing information asymmetry between owners and management, and (2) the assurance value of certification is reflected in the stock price of the certifying company. Overall, the empirical results are consistent with our hypotheses. We observe, on average, positive abnormal returns for firms whose CEOs/CFOs certified their financial statements by August 14, 2002. Based on an analysis of bid-ask spreads, certifying firms experienced a significant decline in information asymmetry after certification. In cross-sectional analyses, we find abnormal returns are positively associated with firms that were under investigation, that used Andersen as their auditor, and that practiced aggressive revenue recognition.

We investigate the risk relevance of the standard deviation of three performance measures: net income, comprehensive income, and a constructed measure of full-fair-value income for a sample of 202 U.S. commercial banks from 1996 to 2004. We find that, for the average sample bank, the volatility of full-fair-value income is more than three times that of comprehensive income and more than five times that of net income. We find that the incremental volatility in full-fair-value income (beyond the volatility of net income and comprehensive income) is positively related to marketmodel beta, the standard deviation in stock returns, and long-term interest-rate beta. Further, we predict and find that the incremental volatility in full-fair-value income (1) negatively moderates the relation between abnormal earnings and banks' share prices and (2) positively affects the expected return implicit in bank share prices. Our findings suggest full-fair-value income volatility reflects elements of risk that are not captured by volatility in net income or comprehensive income, and relates more closely to capital-market pricing of that risk than either net-income volatility or comprehensiveincome volatility.

We present a rational model of earnings management. An informed manager, whose compensation is linked to the stock price, trades off the benefit of boosting the stock price by inflating the reported earnings against the costs of such manipulation. The investors rationally interpret his actions and adjust the price accordingly. When the distribution of true earnings and the compensation scheme are smooth, the conventional equilibrium in this signaling framework is also smooth and fully revealing. In this paper, we show that in the same “smooth” environment there exist equilibria in which kinks and discontinuities emerge endogenously in the distribution of reported earnings. The manager optimally chooses a partially pooling strategy, introducing endogenous noise into his report. The resulting vagueness enables the manager to reduce the average manipulation costs. The equilibrium has perfect revelation of earnings in the right and left tails of the distribution, while for intermediate earnings realizations, we get one or more pools that manifest themselves as discontinuities in the distribution of reported earnings. We study the properties of these partially pooling equilibria and suggest applications to financial reporting.