The petrochemical industry employs assets subject to temporal and site specificity. The OPEC oil price shocks of the 1970s made it difficult to write contracts covering business dealings in the industry. I use this production and economic setting as a natural experiment to test transaction cost theory. In support of the theory, I find that input price uncertainty in the 1970s positively affected the extent of vertical integration by firms into input stages. Moreover, the positive reaction of vertical integration to price uncertainty mainly occurs in transactions subject to asset specificity. I also examine price controls and market power as alternative explanations for vertical integration in the industry, but fail to find support for these hypotheses.

Damage measures in securities fraud cases are very imprecise because they are based on security price changes that reflect both the correction of previous misrepresentation and other independent information. Consequently, potential plaintiffs have a valuable “free option” to decide whether or not to file suit, and average damage awards are greater than actual damages, much greater when markets are volatile. The “Private Securities Litigation Reform Act of 1995” was intended to curb abusive litigation and to address the problem of excessive damage awards. Motivated by a misdiagnosis that excess awards are due to temporary price drops, the Act limits damages to the difference between the purchase price and the time-averaged trading price from the release of the corrective information until 90 days later or until the sale of the security, whichever is first. Unfortunately, the Act's modified measure of damages suffers from a more severe free-option problem than did the traditional measure. Also, the Act introduced an additional new option to time the sale of the security; the effects of these options may be mitigated by the impact of the positive drift in stock prices over time, if the time-averaged price is not adjusted for market movements. As a result, the bias can be larger or smaller under the new Act, depending on how severe the free-option problem is. We propose an alternative approach to addressing the issue of excessive damages: courts should adopt a threshold of measured damages below which no damage would be awarded. The threshold would depend on several factors, most notably the volatility of the stock in the period under question. That is, damages will be awarded only if measured damages exceed the threshold, and awards would be capped by the formula presented in the Reform Act. Journal of Economic Literature Classification Numbers: K22, G38.

This study shows that shareholders of a firm that divests assets receive gains that are significantly related to stock ownership by the firm's managers and to the proportion of outside directors on the firm's board when the divestiture produces positive total dollar gains. Our results agree with the notions that higher levels of ownership give managers the incentive to sell assets that create negative synergies, the incentive to negotiate the best price for shareholders, and that outside directors fulfill their responsibilities as effective monitors and advisors to management.

This study experimentally examines how industry specialization affects auditors' inherent risk assessments and their confidence in those risk assessments. Two groups of participants ‐ experienced banking specialist auditors and equally experienced nonbanking auditors ‐ provided inherent risk assessments for a hypothetical banking client for two financial statement accounts. They assessed inherent risk for an industry‐specific account (loans receivable) and for a nonindustry‐specific account (property and equipment). The results indicate that nonbanking auditors assessed inherent risk significantly higher than industry specialists for all but the valuation assertion for the loans receivable account. However, the difference between the nonbanking auditors' and banking specialists' inherent risk assessments was not as great for the property and equipment account. Further, nonspecialists were less confident about the appropriateness of their inherent risk assessments compared with industry specialists. Potential implications for research and practice are discussed in light of the study's findings.

Some companies now outsource their internal audit function to public accountants. Internal auditors and accounting firms disagree about the merits of outsourcing. Each type of auditor claims to provide more cost‐effective services and appears to claim superior expertise. This paper uses agency theory to examine outsourcing and reconciles the outsourcing debate without resorting to differential auditor expertise. Under the assumptions that public accountants' “deep pockets” provide incentives to outsource and their higher opportunity cost provides a disincentive, we characterize the optimal employment contract with each auditor. We find that public accountants provide higher levels of testing, but possibly for a higher expected fee. This result supports both the internal auditor's claim as the lower cost provider, and the public accountant's claim of higher quality. We also find that incentives to outsource generally increase in various measures of risk, including the risk that a control weakness exists and the size of the loss that can result from an undetected control weakness.

This paper develops asymptotic distribution theory for GMM estimators and test statistics when some or all of the parameters are weakly identified. General results are obtained and are specialized to two important cases: linear instrumental variables regression and Euler equations estimation of the CCAPM. Numerical results for the CCAPM demonstrate that weak-identification asymptotics explains the breakdown of conventional GMM procedures documented in previous Monte Carlo studies. Confidence sets immune to weak identification are proposed. We use these results to inform an empirical investigation of various CCAPM specifications; the substantive conclusions reached differ from those obtained using conventional methods.

We examine corporate disclosure activity around seasoned equity offerings and its relationship to stock prices. Beginning six months before the offering, our sample issuing firms dramatically increase their disclosure activity, particularly for the categories of disclosure over which firms have the most discretion. The increase is significant after controlling for the firm's current and future earnings performance and tends to be largest for firms with selling shareholders participating in the offering. However, there is no change in the frequency of forward-looking statements prior to the equity offering, something that is expressly discouraged by the securities law. Firms that maintain a consistent level of disclosure experience price increases prior to the offering, and only minor price declines at the offering announcement relative to the control firms, suggesting that disclosure may have reduced the information asymmetry inherent in the offering. Firms that substantially increase their disclosure activity in the six months before the offering also experience price increases prior to the offering relative to the control firms, but suffer much larger price declines at the announcement of their intent to issue equity, suggesting that the disclosure increase may have been used to “hype the stock” and the market may have partially corrected for the earlier price increase. Firms that maintain a consistent disclosure level have no unusual return behavior relative to the control firms subsequent to the announcement, while the firms that “hyped” their stock continue to suffer negative returns, providing further evidence that the increased disclosure activity may have been hype, and suggesting that the hype may have been successful in lowering the firms' cost of equity capital.

Some companies now outsource their internal audit function to public accountants. Internal auditors and accounting firms disagree about the merits of outsourcing. Each type of auditor claims to provide more cost-effective services and appears to claim superior expertise. This paper uses agency theory to examine outsourcing and reconciles the outsourcing debate without resorting to differential auditor expertise. Under the assumptions that public accountants' “deep pockets” provide incentives to outsource and their higher opportunity cost provides a disincentive, we characterize the optimal employment contract with each auditor. We find that public accountants provide higher levels of testing, but possibly for a higher expected fee. This result supports both the internal auditor's claim as the lower cost provider, and the public accountant's claim of higher quality. We also find that incentives to outsource generally increase in various measures of risk, including the risk that a control weakness exists and the size of the loss that can result from an undetected control weakness.

Valuation, Intangible assets, Components of Goodwill, Acquisitions