The paper analyzes the use of reported accounting earnings and price as a basis for compensating a manager when he trades on private information, and share price is set rationally based on privately held information, publicly available and contractible information, and publicly available but noncontractible information. In addition, we analyze the comparative statics of the compensation on reported earnings and price with respect to changes in the economy.

We analyze how analysts' forecasts relate to investor beliefs and describe the implications of these relations for price and volume reactions to earnings surprises. We show that dispersion among forecasts does not fully capture investor uncertainty. We also show how the relations between market reactions and forecast properties differ under the alternative assumptions of exogenous and endogenous private information acquisition. Finally, the analysis suggests refined tests for volume reactions at the time of an announcement. Our results indicate that the model is useful for understanding and interpreting empirical work and developing empirical tests of market reactions to announcements.

[We reexamine the "uniformity vs. flexibility" debate by considering the consequences of varying the amount of discretion managers have in reporting current period expenses. We study the effects of altering GAAP on both the "internal agency problem" between current shareholders and their manager and the "external agency problem" between current and prospective shareholders. We show that the internal agency problem is ameliorated by expanding discretion, and we exhibit examples where expanding discretion is undesirable when the internal and external agency problems are present concurrently and the nonexpense-related components of earnings are measured with error. We establish that expanding discretion is welfare-enhancing if either the manager's contract is publicly observable or else the nonexpense-related components of earnings are measured without error. These results demonstrate the limitations of evaluating GAAP on a piecemeal, or issue-by-issue, basis.]

Reexamines the `uniformity versus flexibility' debate by considering the consequences of varying the amount of discretion managers have in reporting current period expenses. Effects of generally accepted accounting principles (GAAP) on the `internal agency problem' and the `external agency problem'; Exhibition of the undesirability of expanding discretion.