Peter O. Christensen

Accounting Policies in Agencies with Moral Hazard and Renegotiation

We emphasize the role of accounting policies, and their audit, in an earnings management setting. We use a two–period agency in which three frictions interact: the agent privately observes action (or effort) supply and output, and the initial contract is subject to renegotiation. This creates a setting in which both players’ behavior is of concern, and, importantly, information rationing is efficient. Moreover, this information rationing is directly interpretable as being produced by an accounting policy whose application is ensured by an auditor.

Market Performance Measures and Disclosure of Private Management Information in Capital Markets

Thispaper examines the optimal disclosure policyin a principal/agent setting in which investors and a managerdirectly receive pre-decision, non-contractible signals. Themanagers signal is more informative than the investors signal.Under no disclosure, the market price provides contractible informationabout the investors signal, whereas it does not reveal the investorssignal if the manager fully and truthfully discloses his signal.The Revelation Principle does not apply and we identify conditionsunder which no disclosure dominates full disclosure, and providea ``hurdle model in which partial disclosure strictly dominatesboth no and full disclosure.

Efficient Timing of Communication in Multiperiod Agencies

This paper examines communication in a two-period principal/agent model in which the agent receives a private signal about the second outcome before the first outcome is realized. No communication is compared with communication at three possible dates: before the first outcome (early), at the first outcome/consumption date (normal), and between the initial consumption date and the second outcome (delayed). Delayed communication is shown to have no value if the agents information is perfect, but can have value if it is imperfect. Early and normal communication can be used to smooth compensation across periods and, hence, generally have incremental value over delayed communicationif the agent cannot borrow or save. However, the smoothing benefits disappear if he can borrow and save. Early and normal communication are equivalent if the agent has domain-additive exponential preferences and the private signal is uninformative about the first outcome. If the private signal is informative about the first outcome, the incremental value of early compared with normal communication attains its maximum for medium informativeness. A unifying example is used throughout.

Arbitrage and Risk Sharing in Multi-Period Markets

This chapter extends the single period analysis in the prior chapter to a setting with multiple consumption dates and sequential trading of long-lived securities. The information system publicly reports a signal at each date. It is taken as given in this chapter, whereas in Chapter 7 we explore the impact of varying the public information system. Both Chapters 6 and 7 continue to examine pure exchange settings, i.e., production choice is exogenous and independent of the information system. However, in Chapter 8 we consider settings with endogenous production choices.

Relation between Market Values and Contemporaneous Accounting Numbers

There is a broad interest in the relation between the market value of a firm’s common equity and the accounting numbers reported by the firm. For example, virtually every business school has a course in financial statement analysis for valuation purposes, and both investors and analysts consider the information in accounting reports when making investment decisions or recommendations. Furthermore, there are a large number of empirical studies in which accounting researchers examine this relation. We do not try to summarize or provide specific references to this literature, but we note that there is a significant subset of this research that seeks to understand how market values relate to contemporaneous accounting numbers.1 In some cases, the studies assume that, or explore whether, the accounting reports are a source of investor information, whereas in other studies the accounting numbers are merely viewed as representations of investor information.

Impact of Private Investor Information in Equity Markets

Part B (Chapters 5 through 10) considers the impact of public information in competitive capital markets in which all investors receive the same information and are price takers. Part C (Chapters 11 and 12) considers the impact of private investor information and non-price taking behavior. Why are we interested in private investor information? As accounting researchers we are not interested in private information per se, but we have a particular interest in the interactive effect of public reports and private investor information. For example, it is widely recognized that investors often know much of the information content in an accounting report before it is released. One reason for this is that investors may have acquired that information privately before it is released. The major gain from private information comes from going long or short in a firm’s shares immediately before the release of a public report that causes the price to increase or decrease (and then reversing the position after the information is impounded in the price). Thus, intuitively, one expects investor demand for private information to increase immediately prior to an anticipated public report. Hence, a key question is how the informativeness of the accounting system affects the prior acquisition of private information. In addition, the timely release of earnings forecasts and other management information may reduce the incremental informativeness of a private signal and, thus, reduce the incentive to acquire the private signal.

Introduction to Information in Markets

In their book on cost deterination, Demski and Feltham (1977) characterize accounting as playing both decision-facilitating and decision-influencing roles within organizations. In its decision-facilitating role accounting reports provide information that affects a decision maker’s beliefs about the consequences of his actions, and accounting forecasts may be used to represent the predicted consequences. On the other hand, in its decision-influencing role, anticipated accounting reports pertaining to the consequences of a decision maker’s actions may influence his action choices (particularly if his future compensation will be influenced by those reports).

Production Choice in Efficient Markets

In the pure exchange models considered in Chapters 5, 6, and 7, the dividends associated with each marketed security are taken as given. The sequence of event-contingent dividends paid by a firm can be viewed as representing that firm’s production plan and its dividend (financing) policy. In this chapter we explicitly consider the choice of production plans.

Relation between Market Values and Future Accounting Numbers

In the preceding chapters, the value of a marketed security is represented as the net present value of risk-adjusted expected dividends. The expectations change with the information received by investors, and accounting reports could be a source of that information. Furthermore, even if accounting reports are not the source, accounting numbers may be used in representing investor information. However, the representations used in prior chapters are abstract and provide little direct insight as to how accounting numbers relate to market values.

Strategic Use of Private Investor Information in Equity Markets

In the GS (and HV) models examined in Chapter 11, the informed investors are assumed to act as price takers when they trade on their private information. The investors rationally anticipate the relation between the private information and the equilibrium price, but nonetheless they ignore the effect their trades will have on the information conveyed to uninformed investors through the resulting price. If there are many competing investors who become informed and their individual actions have a relatively small impact on the price, this is a reasonable assumption. Risk aversion plays a key role in these models as it determines how aggressively the informed investors react to their private information. In other settings there are only a few investors, such as insiders, who become informed. Even if they are risk neutral, they may well restrain their trades so as to partially “hide” their private information while still making a profit from its use in their trades.