Ross L. Watts

The investment opportunity set and corporate financing, dividend, and compensation policies☆

We examine explanations for corporate financing-, dividend-, and compensation-policy issues. We document robust empirical relations among corporate policy decisions and various firm characteristics. Our evidence suggests contracting theories are more important in explaining cross-sectional variation in observed financial, dividend, and compensation policies than either tax-based or signaling theories.

Stock Prices and Top Management Changes

This paper studies the association between a firms stock returns and subsequent top management changes. Consistent with internal monitoring of management, there is an inverse relation between the probability of a management change and a firms share performance. This relation can result from monitoring by the board, other top managers, or blockholders. However, unless share performance is extremely good or bad, logit models have no predictive ability. No average stock reaction is detected at announcement of a top management change.

The Relevance of the Value Relevance Literature for Financial Accounting Standard Setting

In this paper we critically evaluate the standard-setting inferences that can be drawn from value relevance research studies that are motivated by standard setting. Our evaluation concentrates on the theories of accounting, standard setting and valuation that underlie those inferences. Unless those underlying theories are descriptive of accounting, standard setting and valuation, the value-relevance literature’s reported associations between accounting numbers and common equity valuations have limited implications or inferences for standard setting; they are mere associations. We argue that the underlying theories are not descriptive and hence drawing standard-setting inferences is difficult. r 2001 Elsevier Science B.V. All rights reserved. JEL classification: M41; M44; G12

The Relation Between Earnings and Cash Flows

A model of earnings, cash flows and accruals is developed assuming a random walk sales process, variable and fixed costs, and that the only accruals are accounts receivable and payable, and inventory. The model implies earnings better predict future operating cash flows than current operating cash flows and the difference varies with the operating cash cycle. Also, the model is used to predict serial and cross-correlations of each firms series. The implications and predictions are tested on a 1337 firm sample over 1963-1992. Both earnings and cash flow forecast implications and correlation predictions are generally consistent with the data.

Agency Problems, Auditing, and the Theory of the Firm: Some Evidence

This paper examines the history of auditing in the U.K. and the U.S. to test whether audits of companies arose as the consequence of governmental regulation or as a voluntary monitoring activity to reduce agency costs and increase firm value. The paper finds that audits existed early in the development of the modern corporation (as early as 1200) and evolved gradually into the type of audit required by the first English companies act (1844). The evidence suggests that the audits monitoring activity is important, if not crucial, to the formation of firms. The audits long survival suggests it is a part of the efficient technology for organizing firms. Differences in the timing of the evolution of professional auditors in the U.K. and U.S. prior to legally required auditing appear to reflect differences in the timing of capital market development in the two countries.

A Market-Based Evaluation of Discretionary-Accrual Models

Considerable research in accounting focuses on the role of accruals in capital market valuation and in contracting. The research shows accruals enable managers to improve on cash flows as a mesure of firm performance. However, since accruals provide managers with a means of managing reportedearnings, previous research also documents evidence of opportunistic accrual management. Opportunistic accruals are estimated using discretionary-accrual models that seek to separate earnings into discretionary accruals and nondiscretionary earnings.

Corporate Financial Statements, a Product of the Market and Political Processes

An outline for a theory of financial statements is presented. Financial statements are viewed as products of both markets and political processes and the interactions among individuals and groups in these processes. Individuals are assumed to maximize their self-interests. Various hypotheses and data are provided to illustrate the theory. It relies heavily on theories of agency, economic regulation and public choice. At this stage, the theory has great promise in explaining the form and contents of financial statements. The theory contrasts with earlier “normative” theories of financial statements and offers an explanation for the forms they take.

The Information Role of Conservatism

In this paper we argue that information asymmetry between firm insiders and outside equity investors generates conservatism in financial statements. Conservatism reduces the manager’s incentives and ability to manipulate accounting numbers and so reduces information asymmetry and the deadweight losses that information asymmetry generates. This increases firm and equity values. Our empirical tests are consistent with our proposition that information asymmetry is significantly positively related to conservatism after controlling for other demands for conservatism. Further, our tests are more consistent with our prediction that changes in information asymmetry between equity investors lead changes in conservatism than the FASB’s proposition that conservatism produces information asymmetry among equity investors. An important implication is that, if the FASB was successful in meeting their stated goal of eliminating conservatism, they would increase information asymmetry between investors, not reduce it. This outcome is inconsistent with the objectives of the Securities Acts. The Information Role of Conservatism

Asymmetric Timeliness of Earnings, Market-to-Book and Conservatism in Financial Reporting

In a regression of earnings on returns, the coefficient on returns is higher when returns are negative. This is referred to as asymmetric timeliness of earnings, and has recently been used extensively as a measure of conservatism in financial reporting. The ratio of market value of equity to book value of equity, or market-to-book, is another commonly used proxy for conservatism. We use the theory of accounting conservatism to explain why and how the book value of equity differs from its market value. Further, our analysis provides insights into the relation between the two proxies for conservatism, asymmetric timeliness and the market-to-book ratio. We hypothesize and find that the sign and magnitude of the correlation between the two measures depends on (a) the horizon over which asymmetric timeliness is measured and (b) the timing of the measurement horizon relative to market-to-book. This version: 10/27/2004 Preliminary and incomplete Comments welcome ∗ Corresponding author Sloan School of Management, MIT E52-325,50 Memorial Drive, Cambridge, MA02142 Email: sugatarc@mit.edu Phone: 617-253-4903 This paper has benefited immensely from the comments of the seminar participants at MIT Sloan School. All remaining errors are ours.

Incentive and Tax Effects of Executive Compensation Plans

The ability of two (non-mutually exclusive) potential explanations for executive compensation plans is examined. One is that the plans reduce the combined tax liability of the corporation and its managers. The other is that the plans encourage the managers to maximize the value of the firm. It is found that the tax effect can explain some of the popularity of compensation plans, some of the variation in their use across firms, and the timing of changes in the provisions of the plans. However, there are variations in the cross-sectional use of the plans which cannot be explained by taxes, which can be explained by incentive effects.