[This paper shows that persistent mispricing is consistent with a market that includes ambiguity-averse investors. In particular, ambiguity-averse investors may prefer to trade based on aggregate signals that reduce ambiguity at the cost of a loss in information. Equilibrium prices may therefore fail to impound publicly available information. While this creates profit opportunities for ambiguity-neutral investors, ambiguity-averse investors perceive that the benefit of ambiguity reduction outweighs the cost of trading against investors who have superior information. The model can explain both underreaction, such as that evident in postearnings announcement drifts and momentum, and overreaction to accounting accruals.]

This paper shows that persistent mispricing is consistent with a market that includes ambiguity-averse investors. In particular, ambiguity-averse investors may prefer to trade based on aggregate signals that reduce ambiguity at the cost of a loss in information. Equilibrium prices may therefore fail to impound publicly available information. While this creates profit opportunities for ambiguity-neutral investors, ambiguity-averse investors perceive that the benefit of ambiguity reduction outweighs the cost of trading against investors who have superior information. The model can explain both underreaction, such as that evident in postearnings announcement drifts and momentum, and overreaction to accounting accruals. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: [email protected], Oxford University Press.

Most loan contracts in the United States contain a provision for lender voting rules. We study the optimal voting rule that allows lenders to waive a covenant violation. When lenders have heterogeneous preferences, lenient voting rules increase the probability of waivers that allow inefficient investments. Stringent voting rules tend to allocate the marginal vote to lenders who deny waivers after false alarms so that they can renegotiate the loan to extract value from the firm, which incurs deadweight costs. In equilibrium, the optimal voting rule balances these two forces to improve contracting efficiency. We derive and empirically test comparative statics on how the optimal voting rule varies with lenders’ preferences and the borrower's accounting properties. Our model offers a rationale for the prevalent use of voting rule clauses in syndicated loan contracts.

We examine how alternative accounting measures of fair value impact the ability of debt covenants to mitigate inefficient investment decisions. In our setting, shareholders make a non-contractible project choice after signing a debt contract. At a later date, the project can be abandoned and new information determines whether shareholders or creditors make that decision. The value of debt covenants depends on their ability to deter costly asset substitution while also mitigating inefficient continuation decisions. A covenant based on a conservative fair value measure tends to perform best in this respect. Departing from purely fair-value-based covenants, an even more conservative covenant based on fair values and historical cost outperforms those based solely on fair values. Notably, the “highest and best use” measure advocated by the FASB performs poorly in deterring the choice of inferior projects. Our results provide a setting in which the contracting efficiencies associated with different accounting measures cannot be replicated across measures by altering covenant “triggers.”

Recent studies and some policy experts have posited that dividends indicate higher‐quality earnings. In this study, we test this conjecture by comparing the dividend policies of firms accused of accounting fraud to those of firms not accused of accounting fraud. Specifically, we examine whether alleged fraud firms are as likely to be dividend payers as non‐fraud firms, and whether managers of dividend‐paying fraud firms increase dividends at the same rate as managers of non‐fraud firms. Our data reveal that dividend paying status is negatively associated with the probability of committing accounting fraud. In addition, we also find that, during the alleged fraud period, the earnings–dividends relation is weaker for the alleged fraud firms relative to firms not accused of fraud. Finally, using propensity score match tests, the data provide evidence that managers of alleged fraud firms increase dividends less often than managers of firms not accused of fraud, consistent with the alleged fraud firms not being able to match the dividend policies of firms not accused of fraud. Overall, our results suggest that dividends, especially dividend increases, are associated with higher earnings quality.

We examine the relation between workplace safety and managers’ attempts to meet earnings expectations. Using establishment-level data on workplace safety from the Occupational Safety and Health Administration, we document significantly higher injury/illness rates in firms that meet or just beat analyst forecasts compared to firms that miss or comfortably beat analyst forecasts. The higher injury/illness rates in firms that meet or just beat analyst forecasts are associated with both increases in employee workloads and in abnormal reductions of discretionary expenses. The relation between benchmark beating and workplace safety is stronger when there is less union presence, when workers’ compensation premiums are less sensitive to injury claims, and among firms with less government business. Our findings highlight a specific consequence of managers’ attempts to meet earnings expectations through real activities management.

We use required 8-K filings around major borrowings to shed light on firms’ choices of whether to comply with SEC disclosure rules. Exploiting within-firm variation, we find that firms are more likely to hide loans with high spreads and tight financial covenants. We further find that firms appear to exploit the ambiguity of the definition of materiality, as they are more likely to selectively disclose (hide) “immaterial” loans when interest rates are low (high). Firms are less likely to hide loans when investors anticipate borrowing during asset acquisition, when firms are followed by more equity analysts or receive more investor attention, and when the firms’ stock prices are more volatile. Lastly, we provide evidence that the SEC does not rigorously enforce compliance with 8-K loan disclosures.

This study sheds light on the extent to which the use of operating leases depends on reporting incentives, such as understating liabilities, and non-reporting incentives that partly arise from the overlap between accounting, bankruptcy, and tax laws, such as increasing financing capacity and flexibility. We provide evidence that expanding financing capacity, accommodating volatile operations, and maximizing the present value of tax deductions are all important drivers of leasing decisions. Our findings suggest that capital markets and contracting-based reporting incentives have little influence on operating lease use. In particular, we find weak evidence that firms increase operating leases in advance of issuing equity, and no evidence that firms use operating leases to window-dress in advance of issuing debt, to avoid debt covenant violations, for compensation purposes, or to paint a better picture on an ongoing basis. These findings are consistent with reporting incentives playing a second-order role in leasing decisions.

This study models a manager who privately reports earnings to an independent audit committee that, after its own due diligence, modifies the report for public release to investors. The audit committee alters the reporting and valuation dynamics by attempting to remove the manager's reporting bias, but then presents the information it has collected with its own bias. The audit committee's presence changes the impact of penalties and incentives on reporting, valuation, and due-diligence activities. For example, increasing penalties can sometimes degrade the reporting process. Our simultaneous consideration of the manager, audit committee, and investors provides a new framework for reporting and valuation, and sheds light on empirical earnings quality research that has largely studied the management and audit effects separately.