Russell J. Lundholm

Bringing the Future Forward: The Effect of Disclosure on the Returns-Earnings Relation

This paper studies how firm disclosure activity affects the relation between current annual stock returns, contemporaneous annual earnings and future earnings. Our results show that firms with relatively more informative disclosures “bring the future forward” so that current returns reflect more future earnings news. We also find that changes in disclosure activity are positively related to changes in the importance of future earnings news for current returns. These results suggest that a firm’s disclosure activity reveals credible, relevant information not in current earnings, and that this information is incorporated into the current stock price.

Segment Reporting to the Capital Market in the Presence of a Competitor

In this paper we model a firms choice of how finely to report its segmental performance, given that its disclosures will be observed by both a rival firm and the capital market. We find that when competition with the rival is sufficiently severe, the firms value is highest when its privately-observed signals are sufficiently similar and it discloses these signals as separate segments. In this case the capital market becomes better informed yet the rival firm learns very little about where to allocate its capital. Consequently, in equilibrium, only firms with sufficiently similar results from their different activities will choose to report them as separate segments; firms with disparate results will aggregate them together into a single reported segment.

Information aggregation in an experimental market

In this study, the authors report the results from laboratory asset markets designed to test the rational expectations hypothesis that markets aggregate and transmit the information of differentially informed traders. After documenting evidence in favor of the rational expectations model, they examine which features of their environment are necessary or sufficient to achieve an rational expectations equilibrium. The authors find that trading experience and common knowledge of dividends are jointly sufficient to achieve a rational expectations equilibrium, but that neither is a sufficient condition by itself. They also present some stylized facts about the convergence process leading to a rational expectations equilibrium. Copyright 1990 by The Econometric Society.

Reconciling value estimates from the discounted cash flow model and the residual income model

Disclosed is a bearing assembly with thermal compensation. The bearing assembly includes a bearing mechanism defined by a pair of races and a plurality of bearing elements. The races are manufactured from a material having a coefficient of thermal expansion that is substantially different than the coefficient of thermal expansion of the material from which the bearing elements are manufactured. A thermal compensation mechanism of the bearing assembly is contiguous with the races. The thermal compensation mechanism permits movement of the races relative to the bearing elements in a direction parallel the rotational axis of the bearing mechanism as a result of the effect of temperature variations on the materials of the races and bearing elements.

Endogenous Timing and the Clustering of Agents' Decisions

This paper presents a model in which agents choose an action and a time at which to take the action. We show that when agents choose when to act, their decisions become clustered together, giving the appearance of an information cascade, even though information is actually being used efficiently. This occurs because the passage of time allows the first acting agent to anticipate something about the second agents information, and for a large class of delay cost functions, the equilibrium orders agents in such a way that the most extreme information is revealed first.

A Measure of Competition Based on 10-K Filings

In this paper we develop a measure of competition based on management’s disclosures in their 10-K filing and find that firms’ rates of diminishing marginal returns on new and existing investment vary significantly with our measure. We show that these firm-level disclosures are related to existing industry-level measures of disclosure (e.g. Herfindahl index), but capture something distinctly new. In particular, we show that the measure is associated with the rates of diminishing marginal returns within industry, something that traditional industry-level measures of competition cannot do by construction. We find limited and indirect evidence that management strategically makes misleading statements about their competitive landscape. However, on the whole, we find that the disclosures about competition in the 10-K are useful, and relate to firm performance in ways that suggest they meaningfully measure firm-level competition.

Motives for disclosure and non-disclosure: a framework and review of the evidence

Abstract We develop und utilise a theoretical framework for the purpose of summarising the existing empirical work in the voluntary disclosure area. This theoretical framework posits that the primary goal of voluntary disclosure is reduction of information asymmetry (between managers and investors) and thereby cost of capital. We start with a basic or frictionless market where firms choose to disclose all news except worst possible outcomes. The literature supporting this basic economic setting is then discussed. The bulk of our review discusses results that describe disclosure outcomes when frictions do exist. We organise the empirical findings around three categories of frictions: management a) does not know of any information to disclose, b) can not tell information without incurring a cost, or c) does not care about their firms current stock price.

Historical Accounting and the Endogenous Credibility of Current Disclosures

This paper examines how historical financial reporting can serve as an ex post check on more timely voluntary disclosures, and shows that such a check can be sufficient to ensure that the voluntary disclosures are credible most of the time. The model describes an adverse selection setting where an informed seller communicates with an uninformed buyer over time, but there is no exogenous means of making the sellers communication credible. The addition of an ex post report enables the buyer to assess the accuracy of the sellers prior communications and gives the buyer a means to punish a seller who has disclosed falsely in the past. Under certain conditions, this threat of punishment keeps the seller honest in the present most of the time. The model provides a formal means of evaluating the Lundholm (1999) proposal that accounting regulation should turn its attention to supporting credible voluntary disclosures by reporting on the accuracy of past estimates.

A Laboratory Investigation Of The Moral Hazard Problem In An Agency Relationship

Recent developments in agency theory have focused on the moral hazard problem in single-period and multiperiod models. In particular, the literature has emphasized how alternative institutions (e.g., liability rules and long-term contracts) can mitigate the adverse effects of the moral hazard problem. In this study, we use laboratory markets to examine the ability of two such institutions to remedy the adverse effects of moral hazard. We begin by presenting one set of markets with no liability rule from DeJong, Forsythe, and Lundholm [1985], hereafter DFL, where the effects of moral hazard were examined in a market for a service with a hidden characteristic; that is, the principal could not distinguish between shirking and chance as causes of an unfavorable outcome.1 The study showed that moral hazard led to shirking, and while

On Comparing Residual Income and Discounted Cash Flow Models of Equity Valuation: A Response to Penman 2001 (CAR, Winter 2001)*

In the Summer 2001 issue of Contemporary Accounting Research we published a paper arguing that, given a full set of forecasted financial statements, the value estimates from a residual income model and a discounted cash flow model should yield identical results. The reason prior empirical studies (Penman and Sougiannis 1998 and Francis, Olsson, and Oswald 2000) found differences between the models is because of subtle errors in the implementation of the models. Penman (2001) understandably takes issue with our paper, claiming that we are wrong on three points. We feel quite confident in our original paper and will rebut each of Penman’s claims. Penman repeatedly states that he is interested in practical issues surrounding valuation. We share this interest; in fact, we were motivated to write our paper because of the common question raised by students and faculty: “Why do I get a different answer from my discounted cash flow valuation than from my residual income valuation?” We still maintain that, if carefully done, there will be no difference in the valuations from these theoretically equivalent models. Our paper shows exactly how to do this and illustrates commonly made mistakes. Further, any practical attempt to value a firm begins with forecasting future financial statements — earnings and book values at a minimum — and then constructs from these estimates the valuation attributes of interest. All the empirical papers discussed in our original paper started with a complete set of pro forma financial statements. We continue with the maintained assumption that these forecasts are available to both the cash flow and the residual income models. In section 3 of Penman’s paper he gives three criticisms of our claim that cash flow and residual income models should yield the same valuation in all cases. His first criticism is that practical considerations require that forecasts are only made up to a finite horizon, and that this introduces an error in the practical implementation of the theoretical model that is worthy of empirical study. We agree that explicit forecasts for each year can be made only for a finite number of years, but we show in our original paper that this constraint will not create a difference between cash flow and residual income model estimates if treated properly. An inconsistency will arise between the models, and with the forecasted financial