Knowledge that Transforms

This paper examines the factors influencing the relative weights placed on financial and non-financial performance measures in CEO bonus con- tracts. We find that the use of non-financial measures increases with the level of regulation, the extent to which the firm follows an innovation-oriented strategy, the adoption of strategic quality initiatives, and the noise in financial measures. We find no evidence that the choice of performance measures in bonus contracts is associated with the level of financial distress or the value of CEO equity holdings relative to salary and bonus. Our results also provide no support for the hypothesis that CEOs with greater influence over the board of directors are more likely to be compensated based on non-financial measures.

This paper reports the results of an experiment that examines the influenceof uncertaintyabouttheprobabilitythatafuturelosswilloccur (ambiguity) on auditors' and financial statement users' judgments about appropriate reference to contingent losses in audit reports. Application of Einhorn and Hogarth's (1985) ambiguity model suggests that, with respect to losses of low (high) probability, both auditors and users will act as if an ambiguous probability of loss is higher (lower) than a precise probability of the same magnitude, thus demonstrating a conservative (unconservative) reaction to ambiguity. In addition, since auditors may jeopardize client relations when they unnecessarily make audit report reference to contingent losses, auditors may react less conservatively to ambiguity than do users. The results of the experiment support these predictions.

Litigation against auditors has increased dramatically in recent years. Auditors can offset litigation risk in a number of ways, including improved audit quality and planning, increases in audit fees and increases in the issuance of modified opinions. Auditors can also adjust their client portfolios by becoming more selective in their choice of new clients and by withdrawing from high-risk engagements. We test the hypothesis that litigation risk motivates auditor resignations by comparing resignation companies with two groups of client companies that dismissed their auditors: one matched with the resignation companies on industry and year, and the other matched on year alone. We find resignation companies differ from dismissal companies along dimensions that capture the probability of litigation: financial distress, variance of abnormal returns, auditor independence, tenure and a modified (particularly going-concern) opinion. We also construct a litigation proxy based on a prior litigation-prediction model and find that the proxy is positively associated with the probability that the auditor will resign rather than be dismissed from the engagement. Our analysis is consistent with concerns expressed by the accounting profession that litigation pressures lead to the withdrawal of audit services for a segment of the market.

Pownall et al. (1993) document that nearly 80 percent of their sample of voluntary management earnings forecasts are not precise point forecasts. Imprecise forecast forms include closed-interval forecasts (i.e., ranges), open-interval forecasts (i.e., minimums and maximums), and general impressions about firms' earnings prospects. We perform cross-sectional logistic regressions to document determinants of forecast precision. Our sample consists of 1,212 annual and interim management forecasts. After controlling for firm-specific and horizon- specific earnings uncertainty, we find that managers produce more precise forecasts of annual earnings for firms with greater analyst following (our proxy for private information) and for smaller firms (our proxy for public information). The results are robust across subsamples. The majority of the results, however, do not hold for interim forecasts.

This paper develops and tests an option-style valuation model, whose main prediction is that equity value is a convex function of both earnings and book value, where the function depends on the relative values of earnings and book value. Earnings provides a measure of how the firm's resources are currently used. Book value provides a measure of the value of the firm's resources, independent of how the resources are currently used. When the ratio earnings/book value is high, the firm is likely to continue its current way of using resources, and earnings is the more important determinant of equity value. When earnings/book value is low, the firm is more likely to exercise the option to adapt its resources to a superior alternative use, and book value becomes the more important determinant of equity value. Evidence from a variety of empirical specifications is consistent with the convexity prediction.

The effect of disclosure level on the cost of equity capital is a matter of considerable interest and importance to the financial reporting community. However, the association between disclosure level and cost of equity capital is not well established and has been difficult to quantify. In this paper I examine the association between disclosure level and the cost of equity capital by regressing firm-specific estimates of cost of equity capital on market beta, firm size and a self-constructed measure of disclosure level. My measure of disclosure level is based on the amount of voluntary disclosure provided in the 1990 annual reports of a sample of 122 manufacturing firms. For firms that attract a low analyst following, the results indicate that greater disclosure is associated with a lower cost of equity capital. The magnitude of the effect is such that a one-unit difference in the disclosure measure is associated with a difference of approximately twenty-eight basis points in the cost of equity capital, after controlling for market beta and firm size. For firms with a high analyst following, however, I find no evidence of an association between my measure of disclosure level and cost of equity capital perhaps because the disclosure measure is limited to the annual report and accordingly may not provide a powerful proxy for overall disclosure level when analysts play a significant role in the communication process.

[This paper examines experienced managers' judgments about the effects of market price and accounting profit information on negotiated transfer prices. Conventional economic arguments predict that market price should determine negotiated transfer prices by determining reservation prices for parties with outside options. We found, however, that experienced managers expected the influence of market price to be limited by divisional managers' concern about how their profits compare with each other. While market price did affect managers' reservation-price and transfer-price estimates, its influence was significantly less when market price resulted in a more unequal ("unfair") distribution of profits between divisions. Profit comparisons also affected the judgments that determine the efficiency of the bargaining process. We found that as market price diverged from a price that offered equal profits to both divisions, both variance and bias in managers' price estimates increased, indicating that it would be harder to reach agreement on a transfer price.]

[Stock dividends which increase outstanding shares by less than 25 percent require a transfer from retained earnings of the market value of the new shares, a much larger transfer than that required for stock dividends of 25 percent or more. Choosing a distribution factor near, but below, 25 percent may be an indication of management optimism that future income will replenish retained earnings, avoiding constraints on future cash distributions. In this study, firms declaring 20 percent and 25 percent stock dividends are compared. The 20 percent stock dividend firms exhibit significantly greater announcement-period abnormal returns and significantly greater post-declaration cash dividend growth. These effects are greatest for firms incorporated in states where the level of retained earnings more strictly constrains the payment of cash dividends.]

[This paper analyzes seven mandated disclosures contained in Management Discussion and Analysis (MD&A) to assess their information content. Generally, the results show that certain MD&A disclosures, particularly the discussions of future operations and planned capital expenditures, are associated with future (short-term) performance measures and investment decisions, after controlling for information contained in financial-statement-based ratios. However, the associations with longer-term results are generally not significant. The study illustrates that, in conjunction with the financial statements, the MD&A disclosures, especially prospective disclosures, can assist in assessing firms' future (short-term) prospects.]

[This paper reports the results of an experiment that examines the influence of uncertainty about the probability that a future loss will occur ("ambiguity") on auditors' and financial statement users' judgments about appropriate reference to contingent losses in audit reports. Application of Einhorn and Hogarth's (1985) ambiguity model suggests that, with respect to losses of low (high) probability, both auditors and users will act as if an ambiguous probability of loss is higher (lower) than a precise probability of the same magnitude, thus demonstrating a conservative (unconservative) reaction to ambiguity. In addition, since auditors may jeopardize client relations when they unnecessarily make audit report reference to contingent losses, auditors may react less conservatively to ambiguity than do users. The results of the experiment support these predictions.]