17 Theory
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ItemA Theory of Principles-Based Classification( 2020-08-18)We study a firm's decision to classify transactions as recurring or nonrecurring in a setting with no fixed classification scheme, but with the following principle: recurring transactions must be more persistent than nonrecurring ones. Under this principle, equilibrium firm behavior provides a new explanation for the observed relationship between income and classifications. Moreover, we find that market prices are more informative under principles-based classifications than they would be under a hypothetical, optimally chosen specific classification rule
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ItemInformation Design in Coordination Games with Risk Dominant Equilibrium Selection( 2020-08-18)We study the design of public information structures that maximize the probability of selecting a Pareto dominant equilibrium in symmetric (2 x 2) coordination games. Because the need to coordinate exposes players to strategic risk, we treat the designer as able to implement an equilibrium only if the players believe it is also risk dominant. The designer's task is therefore to pool the set of states in which the desired equilibrium is risk dominant with the largest possible set in which it is not, while keeping the desired equilibrium risk dominant in expectation. We provide a simple characterization of the optimal signal structure which holds under general conditions. We extend the analysis to related problems, and show that our intuition is robust, suggesting that our approach provides a promising way forward for a large class of problems in constrained information design.
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ItemInformation Design in Financial Markets( 2020-08-16)We study the optimal disclosure policy of a firm that wishes to maximize its expected stock price in the classic setting in which its stock is traded by risk-averse investors and noise traders. We find that the optimal disclosure policy is imprecise and leads to skewed posterior beliefs. This policy subjects short positions to tail risk, causing investors to demand a large increase in price to absorb noise-trader purchases and leading to overvaluation. Our results suggest that when firms have flexibility in their disclosure choice, disclosure need not improve price efficiency nor enhance liquidity.
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ItemAccounting and the Financial Accelerator( 2020-08-15)We extend the general equilibrium economy of Holmstrom and Tirole (1997) ¨ to optimal reporting of productive assets and examine when the accounting process can contribute to fnancial acceleration. Given a small change in aggregate capital stock, the economy may respond with large readjustments in accounting policies, prices and investment activity. A neutral accounting system, defned as a policy that does not distort decision-making, is optimal when capital is abundant but, after a contraction in aggregate capital, the accounting system becomes initially liberal and then conservative. Surprisingly, accounting policies maximizing frm value, i.e., the net cash flows to shareholders, may lead to self-fulflling equilibria with ineffcient forced liquidations. The theory offers a stylized paradigm to evaluate accounting policies in the aggregate.
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ItemAccounting Harmonization and Investment Beauty Contests( 2020-08-15)We study the optimal degree of harmonization of accounting standards when firms' investments exhibit "beauty-contest" features as in, e.g., Arya and Mittendorf (2016). We model more harmonization of accounting standards as the noises in firms' reports being more correlated, consistent with Barth et al. (1999). We show that while more harmonized accounting standards have ambiguous effects on the reports' informativeness in representing firms' underlying fundamentals, they always reduce the reports' precision in forecasting firms' aggregate investment. The stronger the "beauty-contest" features, the more important the forecasts about the aggregate investment, and thus the less harmonized the standards should be. We also find that, while absent beauty-contest features, mandatory adoption of more harmonized accounting standards can be unnecessary, such mandate is warranted when beauty-contest features are strong. Taken together, our results both provide a justification for and identify an unintended consequence of the recent mandates towards more harmonized accounting standards.
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ItemAsset Transfer Measurement Rules( 2020-08-14)We study the design of measurement rules when banks engage in loan transfers to outside investors. Our model incorporates two standard frictions: 1) banks' monitoring incentives decrease in loan transfers, and 2) banks have private information about loan quality. Under only the monitoring friction, we find that the optimal measurement rule sets the same measurement precision regardless of bank characteristics, and strikes a balance between disciplining banksÂ’ monitoring efforts vs. facilitating efficient risk sharing. However, under both frictions, uniform measurement rules are no longer optimal but induce excessive retention, thus inhibiting efficient risk sharing. We show that the optimal measurement rule should be contingent on the amount of loan transfers. In particular, measurement decreases in the amount of loan transfers and no measurement should be allowed when banks have transferred most of their loans. We relate our results to current accounting standards for asset transfers.
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ItemCECL: Timely Loan Loss Provisioning and Bank Regulation( 2020-08-14)We investigate how provisioning models affect bank regulation. We consider an accuracy vs. timeliness trade-o¤ between two provisioning models, an incurred loss model (IL) and a current expected credit loss model (CECL). Relative to IL, CECL improves efficiency as it allows for timely intervention to curb inefficient ex post asset-substitution, despite that the early information CECL recognizes entails false alarms. However, from a real effects perspective, our analysis uncovers a potential cost of CECL: banks respond to timely intervention by originating riskier loans so that timely intervention induces timelier risk-taking. By appropriately tailoring regulatory capital to information about credit losses, the regulator can improve the efficiency of CECL. In particular, we show that regulatory capital under CECL would be looser when early estimates of credit losses are sufficiently precise and/or risk-shifting incentives are not too severe. From a policy perspective, our model therefore calls for better coordination between bank regulators and accounting standard setters.
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ItemDisclosure and Rational Inattention( 2020-08-13)Investors have a finite capacity to organize all information they receive from financial disclosures. In a model of rational inattention, we show that investor attention capacity affects the probability of disclosure. In the model, an informed firm makes a strategic voluntary disclosure subject to proprietary costs (Verrecchia 1983) or uncertainty about information endowment (Dye 1985), investors optimally allocate their attention as a function of their conjectures about the disclosure strategy. Our main result is that the probability of disclosure is inverse U-shaped in investor attention: for low levels of attention, more attention facilitates communication and increases disclosure; for high levels of attention, more attention better identifies, and therefore deters, unfavorable voluntary disclosure. We provide preliminary empirical evidence that the relationship between investor attention and management forecast is concave and inverse U-shaped, using institutional ownership as a proxy for investor attention.
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ItemAccounting for Compensation: Dynamic Moral Hazard and Optimal Accruals( 2020-08-13)We investigate the impact of accrual accounting policies on contracting and productive efficiency in a continuous-time moral hazard framework. We allow an agent control over unobservable fundamental performance, and he is compensated via a contract written on cash flows, which contain timing errors, and accounting earnings, which correct timing errors at the expense of introducing estimation errors. The equilibrium incentive scheme is less stochastic and more short-term in nature as the accrual policy optimally corrects more timing errors in cash flows. We show that there exist two accrual policies that elicit the desired behavior from the agent. The stationary policy is standardized and does not depend on agency-specific parameters such as risk aversion or discount rates. On the other hand, the non-stationary policy changes over time as the nature of incentive provision changes and depends on such characteristics that are specific to the agency relationship. Neither accrual policy necessarily corrects all of the timing errors in cash flows. Moreover, the choice of accrual policy itself is a dynamic one: the principal will choose to implement the stationary accrual policy during times when the agent's incentives are more deferred, and the non-stationary policy when long-term incentives are closer to being fully vested.
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ItemTo Tell or Not to Tell: The Incentive Effects of Disclosing Employer Assessments( 2020-07-30)Should employers disclose their assessments of their employees? Popular managerial advice suggests that telling an employee that she is assessed to have high potential leads to greater effort and engagement, boosting ï¬ rm proï¬ ts. However, some employers still choose to withhold employee assessments. What explains this observation? We show that if the internal accounting system is weak, telling an employee that she is assessed to have high potential increases her incentive to manipulate the accounting report instead of working harder, thereby decreasing ï¬ rm proï¬ ts. Thus, we explain why some employers withhold employee assessments.