Knowledge that Transforms

Over the past three decades the literature on financial distress prediction has largely been confined to simple multiple discriminant analysis, binary logistic or probit analysis, or rudimentary multinomial logit models (MNL). There has been a conspicuous absence of modeling innovation in this literature as well as a failure to keep abreast of important methodological developments emerging in other fields of the social sciences. In particular, there has been no recognition of major advances in discrete choice modeling over the last 15 years, which has increasingly relaxed behaviorally questionable assumptions associated with the independently and identically distributed errors (IID) condition and allowed for observed and unobserved heterogeneity. In contrast to standard logit, the mixed logit model fulfils this purpose and provides a superior framework for explanation and prediction. We explain the theoretical and econometric underpinnings of mixed logit and demonstrate its empirical usefulness in the context of a specific but topical area of accounting research: financial distress prediction. Comparisons of model-fits and out-of-sample forecasts indicate that mixed logit outperforms standard logit by significant margins. While mixed logit has valuable applications in financial distress research, its potential usefulness in other areas of accounting research should not be overlooked.

This paper reports the results of experiments designed to examine whether investor selection of auditors enhances auditor independence. The experimental design enables us to explore the effect on independence of different institutional rules as to who hires and fires auditors and to directly measure independence violations. The results suggest that transferring the power to hire and fire the auditor from managers to investors significantly decreases the proportion of independence violations. Additional analysis suggests that a reduction in independence violations increases the overall economic surplus generated in the markets examined.

This paper examines whether valuation estimates based on analysts' earnings forecasts are consistent with their stock recommendations. Because earnings forecasts are linked to value and recommendations reflect analysts' opinions of value relative to current price, earnings forecasts and stock recommendations should be linked in a predictable manner. I consider four possible valuation models of how earnings forecasts and stock recommendations are linked. These models include two specifications of the residual income model, a price-earnings-to-growth (PEG) model, and analysts' projections of long-term earnings growth. The results provide little evidence that analysts' recommendations are explained by either residual income model specification. However, both the PEG model and analysts' projections of long-term earnings growth explain analysts' stock recommendations. The relation between the valuation models and future returns is also examined. Analysts' projections of long-term earnings growth have the greatest explanatory power for stock recommendations, but investment strategies based on these projections have the least association with future excess returns. Overall, the evidence suggests that analysts' recommendations are more correlated with heuristic valuation models than with present value models, and buy-and-hold investors would earn higher returns relying on present value models that incorporate analysts' earnings forecasts than on analysts' recommendations.

We investigate two determinants of two choices in the control system of divisionalized firms, namely decentralization and use of performance measures. The two determinants are those identified in the literature as important to control system design: (1) information asymmetries between corporate and divisional managers and (2) division interdependencies. We treat decentralization and performance measurement choices as endogenous variables and examine the interrelation among these choices using a simultaneous equation model. Using data from 78 divisions, our results indicate that decentralization is positively related to the level of information asymmetries and negatively to intrafirm interdependencies, while the use of performance measures is affected by the level of interdependencies among divisions within the firm, but not by information asymmetries. We find some evidence that decentralization choice and use of performance measures are complementary.

We investigate the extent to which the trading and trade-generating activities of three informed market participants—financial analysts, institutional investors, and insiders—influence the relative amount of firm-specific, industry-level, and market-level information impounded into stock prices, as measured by stock return synchronicity. We find that stock return synchronicity is positively associated with analyst forecasting activities, consistent with analysts increasing the amount of industry-level information in prices through intra-industry information transfers. In contrast, stock return synchronicity is inversely related to insider trades, consistent with these transactions conveying firm-specific information. Supplemental tests show that insider and institutional trading accelerate the incorporation of the firm-specific component of future earnings news into prices alone, while analyst forecasting activity accelerates both the industry and firm-specific component of future earnings news. Our results suggest that all three parties influence the firm's information environment, but the type of price-relevant information conveyed by their activities depends on each party's relative information advantage.

Cross-functional teams operate in dynamic environments in which it is difficult to properly align incentives. As a result the free-rider problem can emerge. This paper presents two experiments in which dominant incentives to free ride were held constant. The first experiment examined the question of whether aligning accounting report structure and team structure in such a way as to create a “group frame” helps to mitigate the free-rider problem. Accounting report structure was found to complement team structure. When properly aligned, accounting and team structures helped to resolve the free-rider problem interactively by operating as a powerful group framing device. The second experiment provides theory-consistent evidence that people outside the teams (subjects who acted as management control system designers) fail to appreciate how powerfully the design of accounting and team structures influence performance within teams. Finally, the study provides additional insight into the role that accounting structure can play in promoting informal control within cross-functional teams.

The balanced scorecard provides a framework for selecting multiple performance measures that supplement traditional financial measures with operating measures of customer satisfaction, internal processes, and learning and growth activities. An essential aspect of the balanced scorecard lies in its articulation of the linkage between performance measures and business strategy. This study conducts an experiment to assess how individuals' evaluations of the performance of business unit managers depend on strategically linked performance measures of a balanced scorecard. Statistical test results indicate that performance evaluations are influenced by strategically linked measures more than non-linked measures only when evaluators are provided detailed information about business unit strategies. The results also confirm Lipe and Salterio's (2000) finding that evaluators rely more on common measures than on unique measures. Evaluators rely more on strategically linked measures than on common measures when they are provided information on strategic linkages, but the reverse relation holds when they are not.

The objective of this study is to examine the market valuation of environmental capital expenditure investment related to pollution abatement in the pulp and paper industry. The total environmental capital expenditure of $8.7 billion by our sample firms during 1989–2000 supports the focus on this industry. In order to be capitalized, an asset should be associated with future economic benefits. The existing environmental literature suggests that investors condition their evaluation of the future economic benefits arising from environmental capital expenditure on an assessment of the firms' environmental performance. This literature predicts the emergence of two environmental stereotypes: low-polluting firms that overcomply with existing environmental regulations, and high-polluting firms that just meet minimal environmental requirements. Our valuation evidence indicates that there are incremental economic benefits associated with environmental capital expenditure investment by low-polluting firms but not high-polluting firms. We also find that investors use environmental performance information to assess unbooked environmental liabilities, which we interpret to represent the future abatement spending obligations of high-polluting firms in the pulp and paper industry. We estimate average unbooked liabilities of $560 million for high-polluting firms, or 16.6 percent of market capitalization.

This paper investigates the decision by top-level executives of more than 1,200 public corporations to exercise a large number of stock option awards in the period 1992–2001. We hypothesize and find that abnormally large option exercises predict stock return future performance. We then hypothesize that this predictive ability represents private information about disappointing earnings in the post-exercise period. Consistent with this hypothesis we find that abnormally positive earnings performance in the pre-exercise period turns to disappointing earnings performance in the post-exercise period, and that this pattern comes as a surprise to even sophisticated market participants (financial analysts). We also hypothesize and find that the disappointing earnings in the post-exercise period represent a reversal of inflated earnings in the pre-exercise period. Collectively, these findings suggest that the private information used by top-level executives to time abnormally large exercises follows from earnings management so as to increase the cash payout of exercises.

We propose a multiperiod model to value employee options allowing for the possibility that a risk-averse employee strategically exercises her options over time rather than at a single date. Our results describing the representative employee's option exercise behavior are broadly consistent with existing empirical evidence. The value of options to the employee and their effective cost to the firm are significantly different from the predictions of a constrained model that assumes “single date” strategic option exercise. The constrained model substantially underestimates the cost of options to the firm when, ceteris paribus, the employee's relative risk aversion and/or the time to maturity and/or the stock volatility exceed respective thresholds. Hence, the incorporation of “multiple-date” exercise has important economic and accounting consequences.