Douglas E. Stevens

An Empirical Analysis of the Effects of Online Trading on Stock Price and Trading Volume Reactions to Earnings Announcements

This study provides evidence on the effects of online trading on stock price and trading volume reactions to quarterly earnings announcements. We test for differences in stock price and volume reactions to quarterly earnings announcements between a period with a significant amount of online trading (1996-1999) and a period without online trading (1992-1995). We conjecture that online trading has increased the proportion of naive investors in the market. We predict that this will result in (i) a decrease in the average precision of investor information prior to earnings announcements implying higher ERCs, (ii) an increase in differential interpretation of earnings leading to higher trading volume reactions that are unrelated to price change, and (iii) a decrease in differential prior precision leading to a decrease in the association between trading volume and absolute price change. We find evidence consistent with all three predictions. Our findings are relevant for assessing the validity of concerns about online trading expressed by regulators and the validity of theoretical models of trade with asymmetrically informed investors.

Earnings Characteristics and Analysts’ Differential Interpretation of Earnings Announcements: An Empirical Analysis

This study provides empirical evidence on factors that drive differential interpretation of earnings announcements. We document that Kandel and Pearsons forecast measures of differential interpretation are decreasing in proxies for earnings quality and pre-announcement information quality. This evidence yields new and useful insights regarding which earnings announcements are less likely to generate newfound disagreement among analysts and investors. Recent research suggests that investor disagreement can increase investment risk, increase the cost of capital, and cause stock prices to deviate from fundamental value. Therefore, our results support prior intuition that increasing the quality of earnings and pre-announcement information can improve the efficiency of capital markets.

Ethics and Agency Theory: Incorporating a Standard for Effort and an Ethically Sensitive Agent

We study the implications of introducing ethics into the traditional principal-agent model. In our model, the principal specifies a standard for effort at the time of contracting and the agent suffers a utility loss if he chooses not to provide the standard after agreeing to the contract. The magnitude of the loss depends upon the agents ethical sensitivity. We demonstrate the emergence of an optimal flat salary contract. We then examine the interplay between ethical sensitivity and firm productivity in determining the optimal salary contact, and contrast it with the traditional incentive solution. Our results are intuitive and help explain a variety of contracting behavior that is inconsistent with traditional agency predictions.

Is There Room within Principal-Agent Theory for Ethics?

We study the feasibility and desirability of integrating ethics with traditional principal-agent theory. After discussing common objections and potential benefits, we present a principal-agent model that incorporates ethics in a manner that maintains the essential features of the traditional LEN framework. In our integrative model, the principal specifies a standard for effort at the time of contracting and the agent suffers a disutility if he chooses to violate the standard after agreeing to the contract. The magnitude of the disutility depends upon the level of violation and the ethical sensitivity of the agent. Setting ethical sensitivity to zero yields the traditional result that a flat salary is incapable of inducing effort from the agent. When ethical sensitivity becomes nonzero, however, a flat salary solution emerges. We examine the interplay between ethical sensitivity and firm productivity in determining the optimal salary contract. Our study suggests that incorporating ethics enhances both the internal and external validity of principal-agent theory.

Determinants of Budgetary Slack in the Laboratory: An Investigation of Controls for Self-Interested Behavior

This study investigates determinants of budgetary slack using the framework of agency theory and the methods of experimental economics. A computerized, five-period experiment is designed to test the robustness of prior experimental results documenting budgeting behavior inconsistent with economic rationality and self-interest. Similar to prior experiments, pay scheme and information asymmetry are manipulated. In addition, a personality questionnaire and several questions on an exit questionnaire are included to test the effects of reputation and ethical concerns on budgetary slack. A two-way analysis of variance with pay scheme and information asymmetry as factors finds a significant effect for pay scheme, information asymmetry, and their interaction. By controlling social interactions and increasing subject experience, this study is able to document slack levels closer to agency predictions than prior experimental studies. Nevertheless, subjects given the slack-inducing pay scheme are found to restrict the amount of slack in their budgets below 100% (36% to 60% on average) and subjects given the truth-inducing pay scheme are found to build a small but significant amount of slack under most experimental conditions (3.2% to 4% on average). A regression analysis with non-pecuniary factors added to the model finds that budgetary slack is also reduced by reputation concerns, ethical concerns, and a measure of ethical responsibility from the personality questionnaire. This study is able to explain more of the variance in slack than prior studies using traditional agency variables alone.

The Changing Behavior of Trading Volume Reactions to Earnings Announcements: Evidence of the Increasing Use of Accounting Earnings News by Investors: Changing Volume Reactions to Earnings

The increase in investor diversity over the last 35-40 years (ICI 2014) prompted us to revisit trading volume reactions to earnings announcements and how these reactions vary with firm size. This increase in investor diversity would likely lead to an increase in differences in the precision of pre-announcement information and potentially increase the importance of earnings announcements to resolve investor disagreement. We find that the nature of trading volume reactions to earnings announcements has fundamentally changed over the 35-year time period 1977-2011. There has been a dramatic increase in the magnitude and frequency of volume reactions to earnings announcements over this time period, and this effect is more pronounced in large firms where volume reactions were previously infrequent. The increase in large firms’ trading volume reactions is so pronounced that the relation between volume reactions and firm size has turned positive in recent years, thereby reversing Bamber’s (1986, 1987) previously documented negative relation. We provide intuition and empirical evidence that our results are attributable to the resolution of differential prior precision among an increasingly diverse set of investors following large firms.

Information System Precision and Honesty in Managerial Reporting: A Re-Examination of Information Asymmetry Effects

Hannan, Rankin, and Towry (2006, HRT hereafter) propose that an information system is capable of affecting honesty in the managers budget report by reducing information asymmetry between the manager and the owner regarding the level of honesty in the budget. They find that going from no information system to a coarse information system increases honesty in managerial reporting. However, they also report evidence that going from a coarse information system to a precise information system decreases honesty in managerial reporting. We extend HRTs study in two ways. First, we extend their behavioral theory by incorporating the possibility that reducing information asymmetry could increase the managers preference for honesty in the budget (Koford & Penno, 1992; Bicchieri, 2006). Second, we note that HRT held information system accuracy constant at a relatively low level, which is another source of information asymmetry. Thus, we test the robustness of HRTs negative precision result by manipulating information system precision and accuracy at two levels using a computerized version of their manual experiment. We find that information system precision increases honesty in managerial reporting and that this positive precision effect is weaker under low information system accuracy. A supplemental analysis suggests that our data are generally similar to HRTs data in our two low accuracy conditions and that their negative precision result is attributable to an unusual period effect in their coarse information system condition.

Can Moral Reasoning Reduce Auditor Misreporting? An Experimental Examination of Investor Salience and an Auditor Sign-Off Requirement

Researchers have questioned whether individual differences in moral reasoning might partly account for the variation in auditor misreporting behavior documented in prior experimental-markets research in auditing. In the first experimental market study to directly test the relation between moral reasoning and auditor misreporting, however, Schatzberg et al. (2005) find that auditor misreporting is more likely with higher than with lower moral reasoning participants as measured by the DIT (Rest 1979). We re-examine the link between moral reasoning and auditor misreporting by manipulating two factors expected to increase moral reasoning and by using alternative measures of moral reasoning from the JPI-R (Jackson 1994). Using the same experimental audit market setting in Schatzberg et al., we find that auditor misreporting is lower when the investor is another participant in the experiment than when the investor is an abstract robot. Auditor misreporting is also lower when the auditor is required to sign off on the audit report, but only when the investor is another participant. In fact, auditor misreporting essentially disappears when the sign-off requirement is present and the investor is another participant in the experiment. Finally, we find that auditor misreporting is negatively associated with the auditor’s score on two measures of moral reasoning from the JPI-R: Traditional Values and Responsibility. Our results provide strong evidence that moral reasoning can reduce auditor misreporting in a market setting where financial incentives to misreport are present.

The Realism of Self-Interested Opportunism: An Experimental Investigation of Learning, Fairness, and Ethics

We examine the realism of the assumption of self-interested opportunism in agency theory. We place subjects into manager/producer pairs and set parameters so that the producer extracts the highest share of residual earnings from the manager by setting the budget at zero (100% slack) and providing low effort (shirking). Because the budget is public and effort is private, this setting allows us to examine two different forms of opportunism. To establish common knowledge of incentives, we give subjects extensive experience in both manager and producer roles. Finally, we manipulate pair rotation and the ability of the manager to reject the budget. Fully opportunistic levels of slack and shirking are not observed on average, and the two forms of opportunism differ systematically. With experience, subjects learn to build more slack into their budget but do not shirk more. Fairness concerns reduce both forms of opportunism but ethics concerns reduce shirking only. Subject rotation increases shirking but has no effect on slack. While rejection power reduces slack, it also increases shirking with all variables in the model. We discuss the implications of these results for theory and practice.

The Effect of Endogenous Contract Selection on Budgetary Slack: An Experimental Examination of Trust, Distrust, and Trustworthiness

This study examines the effect of endogenous contract selection on budgetary slack using two slack-inducing contracts found in the literature: a trust contract where the superior must accept any feasible budget submitted by the subordinate and a discretion contract where the superior can accept or reject the budget. We find that both contracts generate less budgetary slack when they are endogenously selected by the superior than when they are randomly assigned by the experimenter. Exit questionnaire responses support our expectation that selecting a trust contract signals trust and expectations of trustworthiness whereas selecting a discretion contract signals distrust and an increased willingness to reject unreasonable budgets. We find the greatest level of efficiency with the endogenously selected discretion contract, which is not significantly different in efficiency than the optimal hurdle contract under traditional agency assumptions. Thus, our results suggest that endogenous contract selection improves efficiency whether it signals trust or distrust and signaling distrust may be optimal for the firm in some contracting settings.