Nahum D. Melumad

Can “Big Bath” and Earnings Smoothing Co‐exist as Equilibrium Financial Reporting Strategies?

We study a model of financial reporting where investors infer the precision of reported earnings. Reporting a larger earnings surprise reduces the inferred earnings precision, dampening the impact on firm value of reporting higher earnings, and providing a natural demand for smoother earnings. We show that for sufficiently “bad” news, the manager under‐reports earnings by the maximum, preferring to take a “big bath” in the current period in order to report higher future earnings. If the news is “good,” the manager smoothes earnings, with the amount of smoothing depending on the level of cashflows observed. He either over‐reports or partially under‐reports for slightly good news, and gradually increases his under‐reporting as the news gets better, until he is under‐reporting the maximum amount for sufficiently good news. This result holds both when investors are “naive” and ignore management’s ability to manipulate earnings, or “sophisticated” and correctly infer management’s disclosure strategy.

Communication in settings with no transfers

Consider a setting commonly found in intrafirm, regulatory, and political relationships wherein an uninformed decision maker, attempting to elicit information from an informed party affected by his decision, is unable to use transfers. This article examines whether both parties will agree on the introduction of communication-based organizational structures; results in prior research suggest they will. In contrast we demonstrate that when there is enough disagreement between the two parties, introducing communication benefits the decision maker but leads to a loss for the informed party. This result holds both when the decision maker can commit to a decision rule (as in Holmstom (1977)) and when he cannot (as in Crawford and Sobel (1982)). We also show that in the commitment case, with enough disagreement, the optimal communication-based decision rule is discontinuous. Our results suggest a possible rationale for observed legal and regulatory limitations on the information decision makers can elicit from other parties, as well as for attempts by various parties to avoid preplay communication.

Delegation as Commitment: The Case of Income Tax Audits

In this article we study the value of delegating authority over income tax audit policy, arising from the incompleteness of contracts. Consider a utilitarian government whose ability to commit is limited to aggregate dimensions of its audit policy, as publicly verifiable information about detailed allocations of audit budgets is not available. We show that the welfare level associated with the full-commitment solution can be attained by delegating authority over audit policy to a manager. The latter is offered a simple incentive scheme based only on the aggregate variables which are publicly observable. In contrast, if the government retains authority, direct commitment to these same variables does not allow the full-commitment welfare level to be achieved. Thus, despite sharing a common informational basis, delegation may perform better than centralized arrangements in the presence of incomplete contracts.

A theory of responsibility centers

Abstract We consider a principal-agent model to examine the effectiveness of responsibility centers, in particular cost or profit centers. We show that rather than contracting with each agent directly, the principal can create equally powerful incentives by setting up a responsibility center structure. The principal contracts with only the ‘manager’ of the center and delegates contracting with other agents and coordinating their activities. The principal then must monitor some measure of financial performance such as the centers cost of profit. We also find that responsibility centers dominate direct contracting with the agents when communication is limited.

Value of communication in agencies

Abstract Focusing on an agency model in which the agent receives private information prior to contracting, we analyze whether the principal benefits from offering the agent a menu of contracts. We show that, under certain conditions, the constraints imposed by the self-selection requirement are so restrictive that a menu of contracts has no value, i.e., the principal might as well offer a single contract based only on some jointly observed outcome. Conversely, we identify cases where a menu of contracts is valuable because it allows the principal to implement a more efficient incentive structure.

Centralization Versus Delegation and the Value of Communication

Management literature has long debated the comparative advantages of centralized versus decentralized decision making. The usual framework of analysis focuses on an organization that consists of a principal (central management, headquarters) and one or several agents (local managers, divisions). Centralization, it is argued, allows the principal to retain control over important decisions. On the other hand, relevant information is generally dispersed among the members of the organization. To exploit the relevant information for decision making the principal must either elicit information or delegate decision making. Delegation has not played a prominent role in the work on incentive mechanisms. For the most part, this work has focused on revelation mechanisms in which all agents communicate their information to the principal who then makes all the decisions. The Revelation Principle asserts that the maximum performance attainable by some incentive mechanism can be replicated by a revelation mechanism. In particular, any mechanism involving delegation of decision making can, without loss of performance, be replaced by a completely centralized mechanism. The reasoning of the Revelation Principle, however, is valid only in a world of unlimited and costless communication. Firms decentralize, as the management literature points out (see, for example, Kaplan [1982]), precisely because communication is costly and managers have limited abilities to communicate and to process information. These costs and limitations seem essential to explaining the creation of organizational

Comparing Alternative Hedge Accounting Standards: Shareholders? Perspective

We study the economic consequences of alternative hedge accounting rules in terms of managerial hedging decisions and wealth effects for shareholders. The rules we consider include the “fair-value” and “cash-flow” hedge accounting methods prescribed by the recent SFAS No. 133. We illustrate that the accounting method used influences the managers hedge decision. We show that under no-hedge accounting, the hedge choice is different from the optimal economic hedge the firm would make under symmetric and public information. However, under a certain definition of fair-value hedge accounting, the hedging decision preserves the optimal economic hedge. We then demonstrate that long-term and future shareholders prefer a certain definition of fair-value hedge accounting to no-hedge accounting, while short-term shareholders prefer either approach depending on risk preferences and the level of uncertainty. We speculate about circumstances in which a manager would choose not to adopt fair-value hedge accounting when he has the option not to do so.

Divisional versus company-wide focus: The trade-off between allocation of managerial attention and screening of talent

In this paper, we analyze why managers are sometimes induced to maximize local objectives rather than adopt a company-wide perspective. American managers are sometimes criticized in the popular press for adopting a narrow focus, for example, for concentrating on maximizing divisional performance measures rather than pursuing company-wide objectives.1 This concentration, however, is likely to be an optimal response

Line-Item Analysis of Earnings Quality

In this paper, we discuss earnings quality and the related concept of earnings management, focusing on the primary financial accounts. For each key line-item from the financial statements, we summarize accounting and economic considerations applicable to that item, discuss implications for earnings quality, evaluate the susceptibility of the item to manipulation, and identify potential red flags. The red flags and specific issues discussed for the individual line-items provide a framework for fundamental and contextual analysis by academic researchers and practitioners.

The Securities-And-Exchange-Commission And The Financial-Accounting-Standards-Board - Regulation Through Veto-Based Delegation

This paper examines the performance of standard-setting arrangements between the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB). Congress, in the Securities Acts of 1933 and 1934, delegated authority over accounting standards to the SEC which, in turn, delegated the choice of accounting standards to a series of privately funded organizations, the current one being the FASB.1 Since an integral part of the delegation arrangement