Carolyn M. Callahan

Do Adoptions of International Financial Reporting Standards Enhance Capital Investment Efficiency

We examine whether adoptions of International Financial Reporting Standards (IFRS) enhance capital investment efficiency as measured by investment-cash flow sensitivity and value-enhancing risk taking for a comprehensive sample comprised of 10,340 mandatory and voluntary IFRS adoptions across 26 countries during the pre-financial crisis period of 2001-08. In contrast to prior findings for capital market effects of IFRS adoptions, associations between mandatory IFRS adoptions and capital investment efficiency are found to be stronger in countries with weaker legal protections, more concentrated ownership, and prior reporting standards that differ more from IFRS. Thus, our findings lend support to mandatory but not voluntary IFRS adoptions serving to enhance firm-level capital investment efficiency, particularly in countries with weaker investor protections.

An Examination of the Cost of Capital Implications of Financial Interpretation 46

This study examines whether adoption in 2003 of FASB Interpretation No. 46/R (FIN 46), Consolidation of Variable Interest Entities – an Interpretation of ARB No. 51, changes the cost of capital for affected firms. Using comparative analysis on a broad sample of 11,719 firm-quarter observations for 1,389 firms during the period 1998 through 2005, we find evidence FIN 46 significantly increased the cost of equity capital for firms with affected variable interest entities (VIEs), an increase of approximately 50 basis points relative to firms reporting no material effect from the standard. Further, firms consolidating these formerly off-balance sheet structures experienced the largest increase. Taken together, these results suggest that FIN 46 reduced the opportunity for firms to use off-balance sheet structures to artificially reduce their cost of capital, a matter of regulatory concern.

Budget ratcheting and performance

This chapter demonstrates (1) divergence between spending based upon a budget ratcheting model and a benchmark spending model, (2) that this divergence affects organizational performance, and (3) that internal benchmarking enables unit-to-unit performance comparisons, despite claims of organizational or unit uniqueness. We contrast two spending models to examine whether the divergence, or cost estimation gap, affects operating performance across inpatient (n=4,536) and outpatient departments (n=8,438) in 23 U.S. Army hospitals. Using a fixed-effects panel data methodology for fiscal years 2004–2006, we find that unit managers’ spending in this setting is more closely approximated by budget ratcheting. Using multiple performance metrics measured via a DuPont-like decomposition, we find that, within a specified range, operating performance generally improves as resources become constrained. Outside that range, however, we find nonlinear performance effects that approximate a quadratic loss function. Our benchmark model enables clinical department comparisons while controlling for facility, clinical specialty, and case mix severity. The resulting departmental comparability facilitates identification and communication of best practices across the entire Army hospital system. These results should be of interest to corporate executives, government officials, and agency managers who have responsibility for establishing funding mechanisms that include performance-based components.

Bertrand Competition, Market Information and Observability

Recent economics literature shows renewed interest in models of Bertrand competition with cost uncertainty. We continue this reexamination and introduce cost correlation as a way to mitigate the asymmetry of information between firms facing Bertrand competition. We also allow firms to make an investment to decrease the variance of their cost signals. Our results demonstrate that when the firms’ choices of precision of their cost signals are observable, all firms will choose to be uninformed about their marginal costs and price at the average equilibrium price. On the other hand, with unobservable choices of precision, firms will choose as precise information as possible within the cost-benefit trade-off. Because of the correlation between the firms’ marginal costs, the increased precision of the cost signals not only provides better information about a firm’s own cost but also allows the firm to better infer the rivals’ costs and better anticipate their pricing choices.

The Alignment of Internal and External Control Mechanisms: The Differential Market Valuation and Performance Effects in High-Growth Versus Low-Growth Industries

We examine the impact of the alignment of internal control mechanisms (governance and management control systems) with external control mechanisms on market valuation and operating performance for 1,693 firm observations over the period 2000-2006 in high versus low-growth industries. The probability of acquisition (merger activity) is used as a proxy for external control. Consistent with theory, the probability of acquisition is hypothesized to be traded off against the two internal control systems, governance and management control systems. We find that firms in high-growth industries generally experience operational benefits from an internal and external controls alignment that emphasizes external control. In contrast, we find that firms in low-growth industries benefit operationally from an alignment of internal and external controls that emphasize internal controls. Further, we find that in low-growth industries, a control alignment that favors internal controls is directly related to equity and debt market valuation effects, while in the high-growth industry, an emphasis on internal controls is inversely related to equity market valuation effects, yet directly related to debt market valuation effects. This suggests that firms in low-growth industries may not be able to take advantage of the level of external control (merger activity) and may consequently be rewarded for investments in internal control mechanisms. Conversely, in high-growth industries, merger activity or opportunity for external growth may be more important to equity investors than increased investments in internal controls. However, these same internal control investments may serve to protect debt holders who do not stand to gain from risky high-growth firm activities. Our results imply that managements investment in internal control systems may be mitigated by the firms operational environment and its growth strategy, a matter of concern for regulators as evidenced by Sarbanes-Oxley Act.