Jennifer L. Kao

Strategic Forward Contracting and Observability

Recently, Allaz (1992) characterized strategic and hedging incentives for entering forward contracts in a two-stage duopoly setting under the implicit assumption that positions in forward contracts are publicly observable. However, credible disclosure of such positions is, at best, costly and subject to noise. Our purpose in this paper is to examine the effects of observability on the interdependency between strategic and hedging behavior. First, focusing on an Allaz-type setting with Cournot conjectures at both stages, we show that if forward positions are unobservable and the hedging motive is not present, i.e., risk neutrality, then the strategic incentive disappears. In fact, contrary to Allaz, each producer strictly prefers not to engage in forward contracting. However, given that a hedging motive is present, we show that producers engage in forward contracting not only to hedge, but also to exploit the awareness of that motive by their rival. In this case, they behave strategically notwithstanding the absence of observability. We then extend the analysis beyond Allazs setting to consider cases in which uncertainty relates to cost and resolution of uncertainty follows rather than precedes production. When cost uncertainty is resolved before production decisions are made, we show that a hedging motive induces forward positions in the opposite direction to those motivated by strategic incentives and more so in the absence of observability. Lastly, when cost uncertainty is resolved after production, we show that the hedging motive disappears and producers only engage in forward contracting when their positions are observable. Our analysis is relevant to financial reporting practices governing the disclosure of forward contracts.

Market Structure and Audit Fees: A Local Analysis

This study conducts a local analysis of the relation between market structure and audit fees. The research question of interest to us is how audit fees are determined by each practicing local office, after taking into account the auditors own position in a local market and the influence exerted by his or her clients. Appealing to the economic theories of monopoly and monopsony power, we hypothesize a positive audit fee-concentration relation, and a negative audit fee-client influence relation. Results indicate that auditor market concentration is positively associated with the non-Big 6 audit fees but is unrelated to the Big 6 audit fees. Evidence is mixed concerning the client influence hypothesis. When this construct is proxied by the number of rival auditors operating within a geographic area centered on the municipality, the prediction of negative audit fee-client influence relation is strongly supported for both groups of auditors. Results are much weaker using measures developed based on the relative importance of a municipal client to its auditors audit portfolio. The issues addressed in this study are important at a time when the Canadian municipal sector is undergoing major changes because of municipal amalgamation, altering the underlying market structure for audit services and the bargaining position of a municipality vis-A-vis its auditor. More broadly speaking, our analysis implies that when assessing an auditors report for signs of client pressure, the professional oversight bodies and regulatory authorities need to consider the relative, rather than the absolute, bargaining position of the client in question.

Note on risk aversion and sharing of firm-specific information in Duopolies

This note extends earlier work on the effects of risk aversion on the preferences of duopolists to share information. It is shown that the common finding that Cournot duopolists prefer to share firm-specific information no longer obtains for some parameterizations. In particular, the greater the aversion to risk, the larger the parameter regions in which not sharing information is preferred. Copyright 1993 by Blackwell Publishing Ltd.

Public Disclosure of Forward Contracts and Revelation of Proprietary Information

Financial executives of firms engaged in forward contracting have raised concerns that mandated disclosure of those contracts would reveal proprietary information to rival firms. This paper considers the basis for those concerns in the framework of a duopoly in which one privately informed producer enters the forward market prior to production. In choosing its forward position, the firm considers the effects of that position on the forward price and second stage product market competition with its rival. Two regimes are considered: mandated disclosure and no disclosure. Under the former, the contracting firm faces a tension between exploiting its information advantage in the forward market and attempting to influence the production decision of its rival. On average, in equilibrium, the contracting firm gains a first-mover advantage, but at the cost of revealing its private information to its rival and extracting less expected gains from uninformed forward market participants. In contrast, with no disclosure, the contracting firm cannot influence rival firm beliefs, but extracts more expected gains from its private information in both the forward and product markets. On balance, the contracting firm prefers no disclosure. Moreover, parameterizations exist such that the rival also prefers that regime. These findings explain the opposition of respondents to draft proposals of Statement of Financial Standards No. 133.

Has SOX Affected the Association between Fee Dependence and Auditors’ Going-Concern Opinions?

Recently, Li (2009) reports that an auditor’s going-concern decision is unaffected by pressure from her economically important clients in 2001, but is positively affected in 2003. Li attributes these findings to enhanced auditor independence under the Sarbanes-Oxley Act (SOX) of 2002. However, this interpretation seems premature, as failures to issue going-concern reservation are generally regarded as a serious violation of independence which auditors will try and avoid even before the passage of SOX. Moreover, several audit-related SOX provisions did not become effective until 2003. Our study sheds light on Li’s (2009) surprising findings by extending her post-SOX period to 2007 and conducting parallel analyses using a more comprehensive logistic regression model developed by DeFond, Raghunandan and Subramanyam (2002). Unlike Li (2009), we fail to find any association between the incidence of going-concern opinions and economic bonding using either model in 2004–2007. Her findings for 2003 are also very sensitive to model specification and sample choice. We then add to the models an interaction term between economic bonding and an indicator variable, denoting firms with high non-audit service fees in 2001 and hence most affected by SOX. This term is insignificant in 2003–2007, implying that SOX has not improved independence even for targeted firms. Expanding Li’s model to include five additional control variables in DeFond et al. (2002) yields qualitatively similar results as DeFond et al. Thus, the phenomena identified by Li (2009) appear to reflect auditors’ response to the aftermath of accounting scandals and/or the publicity surrounding SOX.