Knowledge that Transforms

This paper makes four contributions to the literature relating accounting choices to CEO compensation. First, it shows that discretionary accruals are associated with CEO cash compensation, a result that holds after controlling for both the nondiscretionary components of income and increases in shareholder wealth. Although significant, the coefficient on discretionary accruals is significantly lower than that on nondiscretionary accruals, which in turn is significantly lower than the coefficient on operating cash flows. Second, the paper shows a differential reaction to positive and negative discretionary accruals —‐ the association between positive discretionary accruals and CEO cash compensation is significantly greater than the association between negative discretionary accruals and CEO cash compensation. Third, the paper shows the association between discretionary accruals and CEO cash compensation varies depending upon the circumstances of the firm. In particular, when positive discretionary accruals allow the firm to reduce or avoid a loss, the association between CEO cash compensation and discretionary accruals is significantly greater. Finally, this paper shows that the association of CEO cash compensation with reported income generally increases with the level of discretionary accruals, consistent with management responding to the incentives provided.

The performance goal for a unit is commonly created by consolidating the goals of its subunits. This paper shows that if it is difficult (easy) for the subunits to achieve their goals, it is almost always even more difficult (easier) for the unit to whole will almost certainly not meet a goal to cut its costs by a certain percentage if the degree of cost cutting is difficult to achieve at the individual subunit levels.

This study evaluates the relation between security returns and funds-based earnings components. We document that proxies for market expectations of the components that are based on measures of historical serial- and cross-dependencies are substantially more accurate than random-walk proxies. Moreover, we detect significantly higher valuations of the operating cash flow component of earnings, relative to current accruals, when market expectations are represented using the dependency-based predictions. Such differential valuation is not detectable for random-walk representations. Contrary to results in Ali (1994), we find incremental information in unexpected cash flows over the whole spectrum (moderate and extreme) of unexpected cash flow realizations.

Economic theory stresses that opportunity costs are relevant to resource allocation decisions, while prior empirical accounting research finds that decision makers tend to ignore or underweight opportunity cost information. This study examines whether accounting knowledge is associated with a decision maker's tendency to ignore opportunity costs in business decisions. The experiment's results indicate that the number of opportunity costs ignored by subjects in a business resource allocation decision is greater for subjects with high-accounting knowledge than for subjects with low-accounting knowledge. The experiment also indicates that subjects with high- accounting knowledge ignore a greater number of opportunity costs when the decision is posed in a business context than when it is posed in a personal context.

We construct a dynamic multi-agent moral hazard model to analyze the interactions among the firm owner, the manager and the auditor. Moral hazard may arise in hierarchical agency because a rational monitoring agent may accept a side payment from the monitored agent for misrepresenting information to the principal. This multi-agent moral hazard problem is the essence of the concern for auditor independence. We show that a "low-balling" compensation scheme and the auditor's legal liability constitute an efficient dynamic contracting mechanism for hierarchical agency. In particular, low balling serves as a substitute for legal liabilities for maintaining auditor independence. Low balling reduces the transaction costs associated with the audit engagement relative to the flat-fee structure and can actually improve auditor independence.