Knowledge that Transforms

[This paper presents an analytical model that explores the impact of auditors' legal liability on audit quality and investment. The model is particularly concerned with the impact of damage measures on investments. The threat of liability payments creates an incentive for the auditor to work hard; however, the potential liability payments can also provide an "insurance" for investors in the event the state of nature is bad. Indeed, if damages are measured based on actual investments, investors can increase the liability payments by over-investing. Thus, the potential transfer of wealth from auditors to investors can lead to an over-investment in risky assets, relative to a socially optimal level, even with a high-quality audit. A socially optimal level of investment can be induced by removing the association between actual investments and liability payments. In my model, a legal regime that can induce the socially optimal level of investment, while still motivating the auditors to exert the socially optimal effort level, consists of a strict liability rule with a damage measure that is independent of the actual investment.]

[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 the voluntary disclosure of nonproprietary information using the model of uncertain information endowment developed by Dye (1985) and Farrell (1986), and extended by Jung and Kwon (1988). The paper focuses on a broad family of functions relating the probability of information acquisition to ex post information quality. The paper shows that for each function there is some region that displays a negative relation between ex ante information quality and the frequency of disclosure. In addition, a sub-family of functions is identified for which ex ante information quality and the frequency of disclosure are negatively related everywhere. These results indicate that the economic intuition that higher informational asymmetry is accompanied by more voluntary disclosure is not generally true.]

[This paper investigates the association between aspects of investors' disagreement around earnings announcements and investors' trading decisions. Theory suggests that trading volume arises because of investor disagreement, but disagreement is a multi-faceted construct. We find that three distinctly different aspects of disagreement each play an incremental role in explaining trading volume around earnings announcements, even after controlling for the magnitude of the contemporaneous price change. These aspects of disagreement are: dispersion in prior beliefs, change in dispersion, and belief jumbling. Dispersion in prior beliefs is the level of variation in expectations before the earnings announcement, change in dispersion is the difference in the level of dispersion in beliefs after vs. before the earnings announcement, and belief jumbling occurs when investors' beliefs change positions relative to each other around the earnings announcement. Our results indicate that each of these three aspects of disagreement is associated with investors' real economic (i.e., trading) decisions around earnings announcements.]

[The quality of capacity planning significantly affects firm profitability, particularly for firms in service industries. In practice, firms use product cost data to infer the expected cost of under- and over-stocking capacity and to determine installed capacity. Theory shows that this is not optimal practice. In light of the informational and computational complexities associated with the optimal theoretical formulation, the use of product cost may be justified as a heuristic. For a multi-product, multi-resource firm, we use simulations to investigate the efficiency of four cost-based decision rules in determining the expected cost of under- and over-stocking capacity. Results indicate surprisingly high performance levels, relative to a benchmark solution. The performance of the product-based planning rule deteriorates as products increasingly share capacity resources. The opposite is true for resource-focused rules. There appears to be significant value from identifying mechanisms to balance installed capacity across resources.]

[Managers frequently encounter situations involving a trade-off between financial reporting and tax reporting incentives. This paper examines whether inside ownership concentration, a proxy for reduced capital market pressure, influences the balance of these two opposing external reporting incentives. The empirical tests use a sample of major asset divestitures to show that, for high tax-rate firms, managers of firms with lower levels of inside ownership concentration realize larger gains or smaller losses, on average. This work extends previous research by combining insights from the micro-economics tax incentives literature and financial reporting incentives literature, and by considering explicitly the effect of a firm-specific variable on the balance between these two incentives.]

[This paper studies information system design in a model of double moral hazard in which there is both a decision problem and a control problem. If either problem is considered in isolation, an information system that provides more public information is preferred. However, an information system that provides less public information can, in fact, be desirable because of an interaction between the two problems. The benefit of choosing an information system that provides less information is that it serves as a substitute for commitment for the principal. The cost is that neither the principal's decision (act) nor the agent's payments can be conditioned on the information. We provide sufficient conditions under which less information and more information are each optimal.]

[The paper demonstrates empirically that earnings prepared according to Generally Accepted Accounting Principles (GAAP earnings) have properties necessary to serve as a substitute for dividends in equity valuation analysis. Dividends reduce subsequent GAAP earnings, and "intrinsic" equity prices calculated by forecasting earnings are thus reduced by current dividends. This behavior is in accordance with the Miller and Modigliani principle-the displacement property-which states that the payment of dividends reduces prices, dollar for dollar. Further, the paper demonstrates that if this displacement is accommodated in calculating equity prices from forecasted GAAP earnings, those prices exhibit the dividend irrelevance property, that is, calculated prices are insensitive to future dividends. Forecasted GAAP earnings cannot be substituted for dividends, dollar for dollar, but the two are substitutes in the sense that the replacement value of expected dividends reduces forecasted earnings, dollar for dollar.]

[This paper examines the factors influencing the relative weights placed on financial and non-financial performance measures in CEO bonus contracts. 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.]

[Prior research has found that loan loss provisions are positively associated with bank stock returns and future cash flows, conditional on less discretionary information about loan default. We find that these positive valuation implications obtain only for loan loss provisions for low regulatory capital banks in the fourth fiscal quarter. Our regulatory capital-based tests are motivated by the idea that increased discretionary loan loss provisions are plausibly good news only for banks which appear to have loan default risk problems based on prior information. Our fiscal quarter tests are motivated by findings in prior literature that suggest that managers have incentives to delay income decreasing accruals until the fourth quarter when the audit occurs, implying that income decreasing accruals are more likely, and therefore more expected, in the fourth quarter than in other fiscal quarters (Mendenhall and Nichols 1988; Boyd et al. 1994).]