Abstract Demonstrates how a manager's concern for reputation can distort reports made to superiors about an investment project and affect a firm's capital budgeting decisions. Managerial investment distortion in the choice between short term and long term projects; Underinvestment of the firm as a result of managerial misreporting; Participative budgeting issues.

[This paper demonstrates how a manager's concern for reputation can distort reports made to superiors about an investment project and hence, can affect a firm's capital budgeting decisions. In the first setting examined, a manager is assumed to know more than her superior about both her personal abilities and the prospects of a project under consideration. A manager's ability has two dimensions-ability to forecast a project's returns and productivity. A more talented manager has both better forecasting abilities and higher productivity than a less talented manager. It is shown that while a more talented manager always reports her assessment of a firm's project truthfully, a less talented manager's report depends on the magnitude of the difference in productivities between the more and less talented managers. When this productivity gap is large, the less talented manager conceals her lack of talent by claiming that the project's returns are low so as to discourage investment by the firm. Shifting blame to factors beyond her control protects the manager's reputation. Such managerial misreporting results in underinvestment by the firm. In contrast, where the productivity gap between a less talented manager and a more talented manager is small, a less talented manager guards her reputation by sometimes reporting favorable prospects and sometimes unfavorable prospects. This leads the firm either to over- or underinvest its resources, respectively. Thus, managerial misreporting occurs in equilibrium because a less talented manager tries to masquerade as a more talented manager, resulting in investment distortions. Whether a manager's concern for reputation exacerbates or mitigates the incentive problem depends on the manager's type. While the labor market forces align the incentives of a more talented manager with those of the firm, they also serve to misalign incentives for a less talented manager. In the second setting, this paper examines managerial investment distortion in the choice between short term and long term projects. Consider a scenario in which the outcome of a short term project is observed publicly earlier than that of a long term project. It is shown that managerial reputation incentives, coupled with superior two-dimensional private information, would cause a more talented manager to implement a short term or a long term project as dictated by the firm's interests, whereas a less talented manager with low productivity would choose a long term project. Through such choice, she is able to delay disseminating project outcome which is also informative about her type. A less talented manager who is relatively more productive would, however, implement a short term project sometimes and a long term project some other times. These investment distortions cannot be avoided either by restructuring the decision-making responsibilities or by the principal's committing to any implementation rules.]

This paper examines the effects of disclosure and recognition requirements on investment decisions when shareholders have limited liability. Firms' investment projects have either high initial pollution prevention costs or high subsequent clean-up costs, and their liability for clean-up costs may be either individual or joint and several. Even with individual liability for clean-up costs, shareholders' limited liability creates an incentive to select the latter project type and to impose costs on the rest of the economy. This tendency is exacerbated when clean-up liability is joint and several. We show that a disclosure requirement cannot have an unambiguous effect on the selection of the “cleaner” project. However, an accrual requirement, together with an accounting-based dividend restriction, is shown to promote choice of the project that imposes lower expected costs on the rest of the economy. Moreover, we find that it is possible for a recognition requirement to have a greater impact in a joint-and-several liability regime than in an individual liability regime.

Abstract Capital market participants collectively may possess information about the valuation implications of a firm's change in strategy not known by the management of the firm proposing the change. We ask whether a firm's management can exploit the capital market's information in deciding either whether to proceed with a contemplated strategy change or whether to continue with a previously initiated strategy change. In the case of a proposed strategy change, we show that managers can extract the capital market's information by announcing a potential new strategy, and then conditioning the decision to implement the new strategy on the size of the market's price reaction to the announcement. Under this arrangement, we show that a necessary condition to implement all and only positive net present value strategy changes is that managers proceed to implement some strategies that garner negative price reactions upon their announcement. In the case of deciding whether to continue with a previously implemented strategy change, we show that it may be optimal for the firm to predicate its abandonment/continuation decision on the magnitude of the costs it has already incurred. Thus, what looks like “sunk‐cost” behavior may in fact be optimal. Both demonstrations show that, in addition to performing their usual role of anticipating future cash flows generated by a manager's actions, capital market prices can also be used to direct a manager's actions. It follows that, in contrast to the usual depiction of the information flows between capital markets and firms as being one way — from firms to the capital markets — information also flows from capital markets to firms.

Capital market participants collectively may possess information about the valuation implications of a firm's change in strategy not known by the management of the firm proposing the change. We ask whether a firm's management can exploit the capital market's information in deciding either whether to proceed with a contemplated strategy change or whether to continue with a previously initiated strategy change. In the case of a proposed strategy change, we show that managers can extract the capital market's information by announcing a potential new strategy, and then conditioning the decision to implement the new strategy on the size of the market's price reaction to the announcement. Under this arrangement, we show that a necessary condition to implement all and only positive net present value strategy changes is that managers proceed to implement some strategies that garner negative price reactions upon their announcement. In the case of deciding whether to continue with a previously implemented strategy change, we show that it may be optimal for the firm to predicate its abandonment/continuation decision on the magnitude of the costs it has already incurred. Thus, what looks like “sunk-cost” behavior may in fact be optimal. Both demonstrations show that, in addition to performing their usual role of anticipating future cash flows generated by a manager's actions, capital market prices can also be used to direct a manager's actions. It follows that, in contrast to the usual depiction of the information flows between capital markets and firms as being one way — from firms to the capital markets — information also flows from capital markets to firms.

Abstract This paper examines the effects of disclosure and recognition requirements on investment decisions when shareholders have limited liability. Firms' investment projects have either high initial pollution prevention costs or high subsequent clean‐up costs, and their liability for clean‐up costs may be either individual or joint and several. Even with individual liability for clean‐up costs, shareholders' limited liability creates an incentive to select the latter project type and to impose costs on the rest of the economy. This tendency is exacerbated when clean‐up liability is joint and several. We show that a disclosure requirement cannot have an unambiguous effect on the selection of the “cleaner” project. However, an accrual requirement, together with an accounting‐based dividend restriction, is shown to promote choice of the project that imposes lower expected costs on the rest of the economy. Moreover, we find that it is possible for a recognition requirement to have a greater impact in a joint‐and‐several liability regime than in an individual liability regime.

Financial reporting, Moral Hazard, Contracting, Accrual accounting

This paper studies two disclosure regimes when a firm with superior private information must rely on a strategic certifier to disclose credibly its prospects. In the ex ante (ex post) disclosure regime, the firm must decide on whether to hire the certifier before (after) observing the certifier׳s noisy assessment. Endogenously determined certification fees can actually cause the disclosure probability to decrease in disclosure precision. In the ex ante regime, favorable disclosures are more informative than unfavorable disclosures because of additional positive signaling effect. In the ex post (ex ante) regime, the certifier has incentives to increase (decrease) the disclosure precision.

We develop a positive theory of accounting standards when standards generate network externalities and differ in the amount of reporting discretion, or flexibility, they provide firms. We evaluate expected value-maximizing firms’ preferences between two standards regimes, rigid and flexible, as the number of firms subject to each standard varies, as the organization of the securities market varies, and as the mapping from the underlying economics of the firms’ transactions to the accounting reports produced under the two standards vary. We also compare firms’ preferences between the two regimes to the preferences of profit-maximizing traders in the firms’ securities.