Knowledge that Transforms

We examine the impact of auditing on public school operations with two objectives: to investigate whether audits provide economic benefits to stakeholders, and how complex compliance rules impact auditing effectiveness. Utilizing auditing time data and a unique opportunity presented by the Quality Basic Education Act in Georgia, we estimate the relative performance of school district operations employing a stochastic frontier estimation technique. We find that auditing produces real economic benefits for stakeholders by mitigating inefficiency in the use of school resources. We also find that stringent compliance rules reduce an audit’s effectiveness but auditors’ experience can help to overcome the problems. The lack of disclosure of auditing costs hinders the ability to conduct a cost-benefit analysis of new requirements. Our analysis supports the notion that auditing is vital to establish governance mechanisms and disclosure of auditing costs is important to adequately evaluate a new policy.

In recent years, quarterly earnings guidance has been harshly criticized for inducing “managerial short‐termism” and other ills. Managers are, therefore, urged by influential institutions to cease guidance. We examine empirically the causes of such guidance cessation and find that poor operating performance — decreased earnings, missing analyst forecasts, and lower anticipated profitability — is the major reason firms stop quarterly guidance. After guidance cessation, we do not find an appreciable increase in long‐term investment once managers free themselves from investors’ myopia. Contrary to the claim that firms would provide more alternative, forward‐looking disclosures in lieu of the guidance, we find that such disclosures are curtailed. We also find a deterioration in the information environment of guidance stoppers in the form of increased analyst forecast errors and forecast dispersion and a decrease in analyst coverage. Taken together, our evidence indicates that guidance stoppers are primarily troubled firms and stopping guidance does not benefit either the stoppers or their investors.

The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), in their joint Financial Statement Presentation project, are reconsidering the basic format of financial statements. The Boards’ preliminary discussions related to this joint project indicate that they intend to modify the required financial statements to increase the proximity of performance‐related information for each reported period. We provide evidence related to this potential change by investigating the effects of financial statement information proximity on investors’ ability to learn the forecast‐relevant time series properties of reported cash flows and accruals. We also examine the role feedback plays in this relationship. Our experimental results suggest that nonprofessional investors are able to more quickly learn the relation between current period cash flows and accruals and future cash flow realizations when financial statement information is presented in a single statement rather than separated into two statements. In addition, we find that nonprofessional investors exhibit lower levels of absolute forecast errors and less forecast dispersion when financial statement information is unified into a single statement. Finally, we provide evidence that nonprofessional investors who receive extensive outcome feedback on a single page initially learn more quickly and later, after learning has leveled off, accurately forecast more consistently than do investors who receive extensive or limited feedback spread across two pages. Overall, our results provide evidence on the effectiveness of alternate financial statement presentation formats and the potential usefulness of receiving more extensive feedback.

This paper investigates whether presentation of special items within the financial statements reflects the firm's underlying economic performance or opportunism. We examine the presentation of recognized special items either as a separate line item on the income statement or aggregated within another line item with disclosure only in the footnotes. Our study is motivated by standard-setting interest in performance reporting and financial statement presentation, as well as prior research investigating managers' presentation choices in other contexts. Using different constructs of persistence to capture the economics of reported special items, we find evidence consistent across a range of specifications that special items highlighted on the income statement are more transitory than those revealed only in the footnotes. For most special items, these results are consistent with this presentation decision reflecting underlying firm performance. For a subset observations -namely, those likely to reflect "big bath" reporting incentives -we provide limited evidence suggestive of opportunism in this presentation decision.

This paper investigates whether managers’ presentation of special items within the financial statements reflects economic performance or opportunism. Specifically, we assess special items presented as a separate line item on the income statement (income statement presentation) to those aggregated within another line item with disclosure only in the footnotes (footnote presentation). Our study is motivated by standard‐setting interest in performance reporting and financial statement presentation, as well as prior research investigating managers’ presentation choices in other contexts. Empirical results reveal that special items receiving income statement presentation are less persistent relative to those receiving footnote presentation. These results are consistent across numerous alternative specifications. Overall, the findings are consistent with managers using the income statement versus footnote presentation to assist users in identifying those special items most likely to differ from other components of earnings — that is, for informational, as opposed to opportunistic, motivations.

Prior research indicates that analysts do not fully adjust for the general downward bias in earnings guidance issued by management. We report the results of two experiments designed to investigate how guidance track record and analysts’ incentives jointly explain the extent to which analysts adjust for guidance bias. Our results suggest that analysts with accuracy incentives adjust for management’s track record of downwardly biased guidance when the bias is relatively small (one cent), but those with relationship incentives do not. Furthermore, the difference in adjustment is larger when the bias track record is inconsistent than when it is consistent. Also, when guidance bias is larger (two cents) relative to smaller (one cent), analysts with relationship incentives partially adjust, as they appear to strike a balance between accuracy and their desire to please management. These findings hold implications for investors, regulators, and the interpretation of prior research.

In this study I examine how analysts process nonfinancial information and how this is affected by the patterns of firms’ nonfinancial information disclosures. More specifically, I examine the association between analyst earnings forecast errors and the persistence of nonfinancial disclosures, both across information content and over time. The study focuses on firms in the wireless industry for the period 1997–2007. The results show that analysts tend to underreact to the information contained in customer acquisition cost, average revenue per user, and the number of subscribers. These are the performance measures that have significant predictive ability for future earnings of wireless firms. Distinguishing between firms on the basis of their nonfinancial disclosure patterns reveals that the above findings are driven primarily by firms with irregular disclosures. There is no evidence of analysts’ inefficiency in evaluating the content of nonfinancial metrics provided by persistently disclosing firms. This implies that the lack of systematic disclosures of performance measures restricts financial analysts’ ability to fully analyze the contributions of these metrics for future earnings.

We investigate how private information and monitoring affect the role of accounting quality in reducing the investment–cash flow sensitivity. We argue that access to private information and direct restrictions on investments are likely to affect the extent to which accounting quality reduces financing constraints. Our results suggest that, for financially constrained firms, banks’ access to private information decreases the value of accounting quality. We further find that, for both financially constrained and unconstrained firms, covenants directly restricting capital expenditures also mitigate the importance of accounting quality. Our results suggest that, when information asymmetry problems are likely to be the largest, accounting quality is most important. However, the importance of accounting quality is mitigated if outside capital suppliers have access to private information and is eliminated if they impose contractual restrictions on investment. We also provide evidence that banks’ access to private information reduces the cash flow sensitivity of cash and mitigates the importance of accounting quality in reducing this sensitivity. This additional evidence suggests that our investment–cash flow sensitivity results are not driven by measurement error of the investment opportunity set.

Pigovian taxation of externalities has limited appeal if the tortfeaser has insufficient resources to pay the damage when it occurs. To defend Pigovian taxation in the presence of judgement-proof agents, its proponents point at the many institutions extending liability to third parties. Yet little is known about the validity of Pigou's analysis in this context. The paper analyses the costs and benefits of extended liability and investigates whether full internalization is called for in the presence of agency costs between potential tortfeasers and providers of guarantees. Its contribution is two-fold. It first shows that the better the firms' corporate governance and the stronger their balance sheet, the more closely taxes should track the corresponding externality. It then develops the first analysis of extended liability when guarantors themselves may be judgement-proof, and the extension of liability may give rise to further externalities. Relatedly, it derives the curvature of the optimal taxation of externalities in a multi-plant firm.

We examine competitive non-linear pricing in a model in which consumers have heterogeneous and elastic demands and can buy from more than one supplier. It is an equilibrium for firms to offer a menu of efficient two-part tariffs, where the discount for one-stop shopping is such that the elasticity of “demand for two-stop shopping” equals two. Compared with linear pricing, non-linear pricing tends to raise profit but harm consumers when: (i) demand is elastic, (ii) there is heterogeneity in consumer demand, (iii) consumers incur shopping costs when buying from more than one firm, and (iv) a consumer's brand preference for one product is correlated with her brand preference for another product. Non-linear pricing is more likely to lead to welfare gains when (iii) and (iv) hold, but (ii) does not.