20 Theory

Permanent URI for this collection


Recent Submissions

Now showing 1 - 10 of 11
  • Item
    The Contract Disclosure Mandate and Earnings Management under External Scrutiny
    ( 2019-09-02) Corona, Carlos ; Kim, Tae-Wook Ryan
    This paper studies the effects of mandating compensation disclosure on executive incentive contracts, and the ensuing effects on earnings management, and shareholders' and social welfare. We develop a moral hazard model with multiple principal-agent pairs facing an external inspector who allocates resources across firms to uncover and penalize earnings management. Contract disclosure confers principals with a first-mover advantage, allowing them to design the contract anticipating the inspector's reaction. However, it may also exacerbate a coordination problem among principals, as they do not consider externalities on other principals caused by the effects of their contract choices on the inspector's scrutiny allocation. We find that, if the penalty the inspector imposes on executives is relatively harsher than that imposed on shareholders, contracts become more strongly contingent on reported earnings, earnings are more severely manipulated, and social welfare increases with contract disclosure. However, disclosure improves shareholders' welfare only if the scrutiny resources available to the inspector are not strongly constrained.
  • Item
    A Theory of Classification
    ( 2019-09-01) Stecher, Jack ; Penno, Mark
    The decision to classify line items as special items or core earnings is designed to signal item persistence. Using information other than persistence, such as the sign of the line item, is known as classification shifting. Although classification shifting is widely seen as earnings management, we demonstrate in a simple classification and reporting game that the commonly observed reporting patterns arise when no misreporting occurs. In fact, signaling persistence rather than misreporting explains additional empirical findings that a misreporting story cannot address. Overall, strategic classification imposes a surprising amount of structure on reports, and we argue that it would be ill-advised to set policy based on a presumption that classification shifting is earnings management.
  • Item
    Trading Volume and Public Information in an Experimental Asset Market with Short-Horizon Traders
    ( 2019-08-31) DeSantis, Mark ; Lunawat, Radhika ; Kanodia, Chandra
    We examine the joint impact of investors’ trading horizons and public information on trading volume. We hypothesize that public information leads to relative homogenization in the traders’ beliefs about the fundamental value of an asset and this reduces their disagreement regarding the fundamental value. Since the long-horizon traders’ trade is motivated by the fundamental value, such reduced disagreement leads to a reduction in trading volume. We further hypothesize that public information leads to polarization in the traders’ beliefs about other traders’ beliefs about the fundamental value and this polarization increases disagreement regarding other traders’ beliefs about the fundamental value. Since short-horizon traders’ trade is motivated by other traders’ beliefs about the fundamental value, such increased disagreement leads to an increase in trading volume. We test these hypotheses in an experimental asset market and find strong evidence in their support.
  • Item
    The Effect of Capital Market Concerns on Specific Investments in the Supply Chain
    ( 2019-08-31) Chen, Hui ; Pfeiffer, Thomas
    The financial market gives significant consideration to supply chain activities of publicly-listed firms, who could in turn use their investments in the supply chain to manage market expectations. We study the effects of the capital market concerns of a publicly-traded retailer that collaborates with a privately-owned supplier in a supply chain. The firms each undertake a relation-specific investment and then bargain over the joint surplus generated by the collaboration. The retailer's market concerns make it a more aggressive bargainer, and able to obtain a higher share of the joint surplus. The investments of both firms increase with the retailer's market concerns when the retailer's investment is sufficiently important for the collaboration. In this case, the retailer benefits from its market concerns. When the supplier's investment is sufficiently important, both firms invest less and the retailer suffers from its market concerns. From the perspective of the whole supply chain, the retailer's market concerns could mitigate or exacerbate the hold-up problem between the two firms and thus could be either beneficial or detrimental. In the extension, we also discuss the observability of the firms' investment decisions as well as the case of two symmetric firms that are both publicly traded.
  • Item
    Measurement Error, Manipulation, and the Value of Ignoring Short-Term Performance
    ( 2019-08-30) Rothenberg, Naomi
    This paper studies the effect of measurement error and manipulation on a principal's preference for whether or not to use a short-term performance measure for firing an agent, whose competence is unknown. The short-term performance measure is an imperfect signal of the firm's unobservable long-term value, but is subject to manipulation, which, if successful, results in a favorable performance measure. A competent agent's successful manipulation is beneficial because it reduces inefficient firing, but an incompetent agent's successful manipulation is costly because of inefficient retention. A more informative signal about the competent agent's performance can either increase or decrease inefficient firing, depending on whether the agent's manipulation is successful. Thus, the principal prefers to ignore short-term performance when the signal about the competent agent's performance is neither accurate nor inaccurate. A more informative signal about the incompetent agent's performance can either increase or decrease inefficient retention, depending on whether the agent's manipulation is successful, and, thus, has a non-monotonic effect on the value of ignoring short-term performance. The results have implications for understanding how short-term performance evaluation can be detrimental to an organization's long-term value due to the costs of the firing and retention errors.
  • Item
    Deceiving Two Masters: The Effects of Financial Incentives and Reputational Concerns on Reporting Bias
    ( 2019-08-22) Schaefer, Ulrich ; Feller, Miro
    We study managers’ decisions to bias financial reports if these reports are used by capital and labor markets to learn about firm value and managerial talent. If managers have private information on their financial and reputational incentives, we identify interactions in the capital and labor markets’ use of reports: The reception of reports in one market motivates reporting bias, which reduces value relevance and price efficiency in the other market. This interaction changes established results and has implications for financial reporting standard setters: We characterize environments where capital market efficiency can be improved by eliminating information on managerial talent from financial reports – even if this information is relevant for investors. This is particularly the case if there is high uncertainty about managers’ reputational concerns and if talent uncertainty represents a small part of the overall fundamental uncertainty.
  • Item
    Audit Partner Identication, Assignment, and the Labor Market for Audit Talent
    ( 2019-08-14) Deng, Mingcherng ; Kim, Eunhee ; Ye, Minlei
    Conventional wisdom suggests that partner identification disclosure can improve audit quality, because it may enhance transparency and individual accountability. Building on a two-period matching model, we argue that the disclosure may distort partner-client assignment - which affects audit quality and/or audit fees - because the disclosure can inform the labor market for audit talent. In a centralized assignment in which an audit firm assigns partners to clients, we find that with the disclosure, audit firms may distort partner assignment - at the expense of lower audit quality - in order to dampen partners' career advancement. In a decentralized assignment in which partners directly bid for clients, the disclosure gives rise to low-balling in the first-period, because partners aggressively lower the audit fees to maximize their career advancement. Our findings identify unintended consequences of audit partner identification disclosure and provide economic reasons for the mixed empirical findings.
  • Item
    How uncertain is the market about managers' reporting objectives? Evidence from structural estimation
    ( 2019-08-13) Bertomeu, Jeremy ; Li, Edward ; Cheynel, Edwige ; Liang, Ying
    Theory suggests that the market's uncertainty about managers' reporting objectives is an important source for reporting biases (Fischer and Verrecchia 2000), yet little empirical work exists on gauging such uncertainty. We derive a simple structural estimator of this uncertainty, incorporating cross-sectional properties of prices, earnings and restatements. This approach enables us to assess an average level of uncertainty. We show that investors' uncertainty about reporting incentives, albeit non-zero, are generally small. Given the link between uncertainty and reporting biases, our large sample evidence also supports the conjecture that earnings management is not as rife as what prior accounting academic publications would make one believe (Ball 2013). We also characterize the variation in the magnitude of uncertainty across industries and subsamples of firm size and growth.
  • Item
    Strategic Withholding and Imprecision in Asset Measurement
    ( 2019-08-13) Cheynel, Edwige ; Bertomeu, Jeremy ; Cianciaruso, Davide
    How precise should accounting measurements be, if management has discretion to strategically withhold? We examine this question by nesting an optimal persuasion mechanism, which controls what measurements are conducted, within a voluntary disclosure framework a la Dye (1985) and Jung and Kwon (1988). In our setting, information has real effects because the firm uses it to make a continuous operating decision, increasing in the market’s belief. Absent frictions other than uncertainty about information endowment, we show that imprecision can reduce strategic withholding but always weakly decreases firm value. We then examine plausible environments under which, by contrast, there is an optimal level of imprecision featuring coarseness at the marginal discloser. We offer additional implications in the contexts of enforcement against strategic withholding and financing with collateralized assets.
  • Item
    Investors Want Both More Risk and More Information
    ( 2019-08-13) Johnstone, David
    Market folklore says that investors abhor uncertainty. But if there were no uncertainty, investors could earn only the risk-free interest rate. So how much risk do investors want resolved? Using a payoffs form of CAPM, I find that the mean-variance investor buying the risky asset is attracted to invest by higher payoff risk. Higher payoff risk, accounted for in the rational asset price, translates unconditionally to higher ex ante expected utility (the payoff mean makes no difference). Also contrary to intuition, resolution of parameter risk can heighten payoff risk - and hence increase expected utility. By distinguishing payoff risk from parameter risk, more is revealed about why decision makers always want more information. Ultimately, both potential buyers and existing owners of a risky asset want more information about it before they trade, but they want it for different reasons