Susan G. Watts

Price Discovery on the NYSE and the NASDAQ: The Case of Overnight and Daytime News Releases

We examine the market response to quarterly earnings announcements made during trading and non-trading hours on the NYSE and the NASDAQ. For non-trading-hours announcements, the opening trade on the NYSE impounds most of the price response, whereas for trading-hours announcement trades. In contrast, the first post-announcement trade on the NASDAQ impounds most of the price response regardless of announcement time. These results suggest that the different trading environments on the two exchanges (e.g., specialist versus dealer market, call auction versus continuous trading, etc.) may differ in their ability to impound information.

Oligopoly, Disclosure and Earnings Management

We examine how biased financial reports (managed earnings) affect how firms compete in the product market and how product market competition affects incentives to bias reported earnings. We find that Cournot competitors bias their financial reports so as to create the impression that their costs of production are lower than they actually are. This bias leads to lower total production, a higher price and each competitor earning greater product market profits. These results obtain even though no firm is fooled by its rivals disclosure. We also find that the magnitude of the bias (the amount of earnings management) is larger when firms compete in more profitable product markets but smaller when they can extract more information about their rivals costs from their own. When the costs of misreporting are asymmetric, the lower cost firm engages in more earnings management than its rival, and it produces more and earns greater profits than it would in a full-information environment. Our analysis also offers new, testable implications for the relationship between earnings management, reported and actual earnings and industry structure.

Around-the-Clock Media Coverage and the Timing of Earnings Announcements

We reexamine the descriptive ability of the conventional wisdom that earnings announcements made after trading and on Friday are dominated by bad news in light of the 24/7 media coverage and other technological changes of the 1990’s. We find that the change in media coverage has facilitated a significant change in earnings announcement times: only 27% of earnings announcements are now made during trading as opposed to 67% in prior research. However, our finding of continued dominance of bad news in Friday announcements in particular strongly suggests that the conventional wisdom is not solely the result of managers’ desire to take advantage of limited media coverage. Instead, managers appear to be taking advantage of other aspects of investors’ behavior, such as their anticipating negative Friday announcements earlier in the week, and the relatively quiet (in terms of trading) weekend period to manage stock price responses to their companies’ financial news.

Financial Reporting and Supplemental Voluntary Disclosures

A standard result in the voluntary disclosure literature is that when the managers private information is a signal correlated with the firms liquidation value, mandatory disclosures substitute for voluntary disclosures. In this paper, we assume that the managers private information complements the mandatory disclosure and show that the content and likelihood of a voluntary disclosure depend on whether the mandatory reports contain good or bad news. This different information asymmetry produces new, testable implications regarding the probability of and market reaction to voluntary disclosures. We also show that changes in mandatory disclosure regulations can have unintended consequences due to their effects on the managers willingness to voluntarily provide supplemental disclosures.

The Effect of Relative Performance Evaluation on Earnings Management: A Game-theoretic Approach

Because investors and creditors often compare the financial statements of similar or competing firms when deciding how to allocate their funds, it is likely that a firms financial well-being depends on how well it performs relative to its rivals. In this paper, we consider the problem of earnings management as a noncooperative game among several firms, in which each firm seeks a comparison advantage through its financial statement numbers. Our model indicates that firms may exaggerate their earnings in a world driven by multi-firm comparisons simply because they expect other firms to do so. Thus, very little may be needed for earnings management to emerge in the Nash equilibrium. Our results hold under the following conditions. First, investors and creditors are not able to unravel the earnings management, thus ensuring that some information asymmetry remains. Second, investors and creditors make interfirm comparisons when assessing firm value. Third, firms care about their own fundamental value as well as the markets perception about firm value. We also show that the equilibrium amount of earnings management depends on the characteristics of the earnings management technique itself and on the proportion of stockholders who are long-term investors in the firm.

Chasing Hot Funds: The Effects of Relative Performance on Portfolio Choice

We study the way in which SEC restrictions on fund manager compensation affect portfolio choice when investors buy into funds whose recent performance has been good. We find that fund managers choose riskier portfolios than they would if there were no contracting restrictions and that these portfolios are riskier than the optimal risky portfolio. Further, if investors choose funds according to performance rank rather than performance relative to the average, these effects are exacerbated—fund managers choose even riskier portfolios. Thus, our analysis suggests a need to provide investors with information about risk-adjusted performance.

Family firms, debtholder–shareholder agency costs and the use of covenants in private debt

We ask whether the private debt contracts of family firms contain more restrictive covenants tied to accounting numbers than those of non-family firms. Our examination of Dealscan data indicates that credit agreements of Standard and Poor (S&P) 500 family firms are more likely to include accounting-based covenants that limit the lender(s)’ risk that managers will divert cash or assets to shareholders than those of S&P 500 non-family firms. The likelihood is further increased by presence of a dual class stock system that includes supervoting shares. Our results suggest that lenders are more willing to rely on accounting-based covenants to solve the shareholder–private lender agency problem in family firms given that the reporting quality is higher due to better alignment of owner and manager interests in such firms.

Reg FD and the Competitiveness of All-Star Analysts

We examine the impact of Regulation Fair Disclosure on the competitive advantage of All-Star analysts as measured by turnover in the rankings. Institutional Investor All-Americans, chosen by votes of institutional investors based on overall helpfulness, experienced a significant increase in turnover as Reg FD was implemented. Non-U.S. analysts and U.S. analysts ranked solely on the basis of public stock recommendations did not. Within a few years, however, All-American turnover returned to pre-Reg-FD levels, suggesting that the new All-Americans built a competitive advantage stressing aspects of performance less dependent on privileged communication.

Forced Voluntary Disclosure

Two–way communication via social media platforms allows the firm to make an initial disclosure decision and then revise it after observing the response on social media to its initial decision. We examine the pressures interactive communications place on disclosure choices and find that negative social pressure “forces” some firm types to respond and disclose information they initially did not disclose. The valuable option to revise reduces the probability of an initial disclosure. Further, an increase in the initial disclosure cost reduces the probability of an initial disclosure but increases the probability of a subsequent disclosure. Similarly, an increase in the cost of a subsequent disclosure increases the probability of an initial disclosure but decreases the probability of a subsequent disclosure. These effects are amplified if the firm is more likely to face social media pressure or if its value is more sensitive to it.

Disclosure of the Estimated Tax Liability from Repatriation of Permanently Reinvested Earnings

Political, financial distress and investment mismatch costs are key costs of disclosing a firm’s estimated tax liability from repatriation. However, we show that they do not affect the manager’s disclosure choice absent other frictions. When proprietary disclosure costs are present, increases in political costs or the probability of an investment mismatch surprisingly increase the probability of disclosure whereas increases in financial distress costs or the costs of financing mismatched projects produce the more standard result that the probability declines. If instead there is a chance the manager is not informed (estimation of the tax liability is actually impractical), increases in non–proprietary disclosure costs are more likely to reduce disclosure relative to the proprietary cost case and the effect is greater the more likely it is that the liability cannot be estimated. Thus, our analysis offers a means of using changes in these costs to distinguish whether disclosure of the estimated tax liability is driven by proprietary disclosure costs or uncertainty about whether the manager has private information.