This paper examines whether differences in accrual accounting methods across balance sheet accounts influence the time‐series process of earnings. We define earnings quality as the responsiveness of earnings to shifts in permanent earnings and predict that responsiveness will increase in a firm's use of variable rate debt, where accruals move directly with shifts in interest rates. We also predict that responsiveness will decrease in a firm's investment in property plant and equipment because depreciation is largely predetermined and does not respond to shifts in opportunity costs. To test these hypotheses, we regress earnings on lagged earnings and a proxy for permanent earnings (that is, the implied dividend annuity in lagged equity value). Within the context of an adjustment cost model, this regression captures the responsiveness of earnings by the coefficient on lagged price and by one minus the coefficient on lagged earnings. Consistent with this framework, we find the unconstrained estimated coefficients on these two variables to be negatively correlated. Furthermore, consistent with our hypotheses, we find that the coefficient on lagged earnings (lagged price) is positively (negatively) associated with the relative magnitude and life of fixed assets on the balance sheet and negatively (positively) associated with the relative magnitude of variable rate debt on the balance sheet.

A firm with two divisions, each run by a risk-averse manager, contracts with the two managers to operate their divisions and possibly engage in interdivisional trade. Each division can increase the total surplus generated through interdivisional trade by making costly relationship-specific investments. The terms of trade are determined through negotiations between the two managers. Managerial compensation contracts are linear functions of divisional profit and firm-wide profit. If managers are compensated solely on the basis of their divisional profits, they invest less than the first-best amounts. While compensation contracts based on firm-wide profits alone can induce first-best investments, they impose extra risk on risk-averse managers. Therefore, we find that optimal linear compensation contracts will contain both divisional and firm-wide components. Our analysis also identifies a feature of negotiated transfer pricing, namely interdivisional risk sharing, and characterizes its impact on the design of optimal contracts.

We examine the effect of higher order beliefs on the ability of decentralized decision makers to coordinate and take advantage of improvements in information transparency that can increase welfare. Theories that address this question have not been empirically explored. We study coordination in a laboratory experiment with privately informed decision makers. Economic outcomes in the setting depend both on agents' rational beliefs regarding economic fundamentals and on their rational beliefs regarding the beliefs of other agents. Increasing information transparency mitigates uncertainty about economic fundamentals but may increase strategic uncertainty, precipitating multiple equilibria and less efficient group outcomes. We provide evidence that sometimes the equilibrium attained by creditors is inferior from a welfare perspective to other available equilibria. Risk dominance appears to determine equilibrium selection in our setting.