Gerald A. Feltham

The role of audits and audit quality in valuing new issues

Abstract This paper provides a model in which audited reports are valuable to entrepreneurs who have private information and seek to share risks with investors. A distinctive feature of the model is that the choice of auditor and the resulting audited report provide partial information about the entrepreneurs private information, and he resolves all remaining investor uncertainty by signalling with retained ownership. The value of an audit is increasing in audit quality and the firm-specific risk faced by the entrepreneur and is a nondecreasing function of the entrepreneurs expectations about the future value of the firm.

Market response to financial reports

Abstract A two-date rational expectations model is analyzed. At the first date, traders can privately acquire a costly signal that provides imperfect information about a public report that will be issued at the second date. Equilibrium characterizations are provided for the fraction of traders that become informed and the informativeness of the first-date price, as well as the price change variance and the expected trading volume at the second date. Comparative statics identify how the above variables are influenced by changes in the information content of the public report, and in particular how market phenomena at the public release date are influenced by endogenous prior information acquisition and trading in response to the forthcoming public release.

An empirical examination of the relation between debt contracts and management incentives

Abstract Prior research on the factors influencing the use of debt covenants restricting dividends and additional borrowing is extended by considering management incentives. When alternative incentive variables are considered separately, we find covenants have a significant, negative relation to CEO cash compensation, an insignificant relation to the value of CEO equity held, and significant positive relations to both the ratio of the value of CEO equity holdings to cash compensation and the fraction of equity held by the CEO. In two-stage simultaneous equations models, only the latter is significant when jointly considered with each of the other incentive variables.

Incentive Efficiency of Stock versus Options

This paper examines the relative incentive costs of using stockversus options in management incentive contracts that use market priceas the performance measure. We establish that if the managerseffort has little or no effect on a firms operating risk, thenthe cost of incentive risk is less using stock rather than options.However, this result is reversed if the managers effort has asignificant impact on the firms operating risk.

Information and the Cost of Capital: An Ex-Ante Perspective

ABSTRACT: Recent articles have demonstrated that increased public disclosure can decrease firms’ cost of capital. The focus has been on the impact of information on the cost of capital subsequent to the release of the information (the ex post cost of capital). We show that the reduction in the ex post cost of capital is offset by an equal increase in the cost of capital for the period leading up to the release of the information (the preposterior cost of capital). Thus, within the class of models framing the recent discussion, there is no impact on the ex ante cost of capital covering the full time span of the firm. The extent to which information is made publicly or privately available affects the timing of the resolution of uncertainty and when the information is reflected in equilibrium prices, but there is no impact on initial equilibrium prices. Within a noisy rational expectations equilibrium, rational investors may actually benefit from a higher ex post cost of capital.

Dynamic Incentives and Responsibility Accounting: A Comment

Revisits the finding of a ratchet effect causing losses through lack of commitment by managers through their contracts by Indjejikian and Narda (1999). Demonstrates that equilibrium can be achieved by assuming the principal can commit in advance to offer a fair second-period contract and the agent can commit to stay for that period. Shows that the principal, by committing to seasonal period incentive rates in advance and to a fair fixed wage, can achieve full efforts from agents. Assumes that principals can offer a long-term contract which is ratchet-proof if no renegation takes place. Concludes that the principals ability, or not, to commit to a second-period incentive rate in advance, is important, since it ties in the agent for a second period.

Analysis of the Impact of Accounting Accruals on Earnings Uncertainty and Response Coefficients

This paper uses the residual income valuation model in Feltham and Ohlson (1996) as the basis for developing a model in which management has private information and their choice of accruals influences the information received by investors. The noisiness of accruals relative to managements private value relevant information is exogenous. The analysis examines how the characteristics of the managements private information and their accrual choice process influences the variance of unexpected earnings and the earnings response coefficient. The variance of unexpected earnings is shown to be an increasing function of the noise in managed accruals, but information enhancing earnings management does not necessarily decrease the variance of unexpected earnings. It depends on the nature of the information. The earnings response coefficient is shown to depend on both the persistence of earnings as well as the informativeness of reported earnings.

Limited Commitment in Multi-agent Contracting

The analysis in this paper extends the single-agent/multi-task LEN model in Feltham/Xie (1994) to a multi-agent/multi-task context. A key feature of the paper is that we consider both full- and limited-commitment contracts. The former apply to settings in which the principal can specify the contracts for each agent and is assured that those contracts will be implemented. The latter apply to settings in which the agents can collude to effectively change the terms of their contracts. Equivalently, limited contracting occurs if the principal can set the terms of the aggregate compensation pool, but must let the agents choose how the pool is allocated among the agents. From the principals perspective, full-commitment contracts dominate limited commitment contracts. There are two basic frictions that result in a reduced payoff with limited commitment. One is inefficient risk sharing which occurs because the agents will choose to share their incentive risk and this results in reduced induced effort. The other is inefficient allocation of effort, which occurs because when the agents allocate the aggregate incentives they ignore the principals payoff and focus on inducing actions that maximize their compensation.

Communication of Private Information in Capital Markets: Contingent Contracts and Verified Reports

Considerable interest has developed in accounting and finance in the communication properties of capital investment contracts. In the typical setting, an agent with private information seeks to raise capital from investors and to share risks with them. Our examination of this investment game has two major purposes: (1) to characterize the equilibria that may emerge under alternative concepts of rational behavior, and (2) to identify conditions under which verified reports concerning the agent’s private information may have value. A key issue in the characterization of equilibria is whether agents with better news always design contracts to “separate” themselves from agents with worse news, or whether there are conditions under which they choose to “pool.” The answer to this question has significant implications for the value of verified reports.

Joel S. Demski: A Leader in Accounting Scholarship

Joel Demski has made significant contributions to accounting research and education for nearly forty years. This paper reviews and highlights many of his scholarly contributions. He has been innovative and thought provoking — always at the leading edge of our discipline