Haresh Sapra

Bridging Theory and Empirical Research in Accounting
Date Posted:Wed, 03 Apr 2024 15:07:44 -0500
Formal theory and empirical research are complementary in building and advancing the body of knowledge in accounting in order to understand real-world phenomena. We offer thoughts on opportunities for empiricists and theorists to collaborate, build on each other?s work, and iterate over models and data to make progress. For empiricists, we see room for more descriptive work, more experimental work on testing formal theories, and more work on quantifying theoretical parameters. For theorists, we see room for theories explicitly tied to descriptive evidence, new theories on individuals? decision-making in a data-rich world, theories focused on accounting institutions and measurement issues, and richer theories for guiding empirical work and providing practical insights. We also encourage explicitly combining formal theory and empirical models by having both in one paper and by structural estimation.

Climate-Related Disclosures: What Are the Economic Trade-Offs?
Date Posted:Thu, 20 Jul 2023 04:48:56 -0500
We study the real effects of climate-related disclosures in a setting in which domestic productions generate direct greenhouse gas emissions while outsourcing to foreign suppliers generates indirect emissions. A key friction in our model is the disparity in the quality and the consistency of emissions data reported across the globe. We show that mandatory disclosures of direct emissions are desirable as firms fail to internalize the long-term environmental losses caused by physical climate risks. However, such disclosures induce emissions leakage by exacerbating indirect emissions. Similarly, mandating indirect emissions disclosures leads to reverse emissions leakage. We show, perhaps surprisingly, that when indirect emissions information is noisier, regulators should mandate less precise disclosures of direct emissions. We also show, regulators should tailor the design of indirect emissions reporting requirements to the compositions of physical vs. transition risk in firms' climate risk profiles. Our results help reconcile the varying approaches policy makers in Europe and the United States have adopted in mandating and designing climate reporting policies.

REVISION: Interplay between Accounting and Prudential Regulation
Date Posted:Tue, 17 May 2022 14:37:40 -0500
We develop a model in which accounting information and prudential regulation interact to affect banks' incentives to originate loans. Prudential regulators impose capital requirements to prevent banks from taking excessive risk. However, regulators cannot commit to ex-ante efficient intervention and, instead, respond to ex-post accounting information. We show that capital requirements and accounting measurement are substitutes when considered separately. By contrast, when considered jointly, accounting measurement and capital requirements are complementary tools that affect the level and efficiency of credit decisions. Comparative statics link capital requirements, quality of accounting information, and regulatory intervention to credit market conditions. An upshot of our analysis is that by appropriately optimizing the information from expected loss models, prudential regulators may design looser capital requirements to spur more bank lending.

REVISION: Interplay between Accounting and Prudential Regulation
Date Posted:Mon, 16 May 2022 13:35:42 -0500
We develop a model in which accounting information and prudential regulation interact to affect banks' incentives to originate loans. Prudential regulators impose capital requirements to prevent banks from taking excessive risk. However, regulators cannot commit to ex-ante efficient intervention and, instead, respond to ex-post accounting information. We show that capital requirements and accounting measurement are substitutes when considered separately. By contrast, when considered jointly, accounting measurement and capital requirements are complementary tools that affect the level and efficiency of credit decisions. Comparative statics link capital requirements, quality of accounting information, and regulatory intervention to credit market conditions. An upshot of our analysis is that by appropriately optimizing the information from expected loss models, prudential regulators may design looser capital requirements to spur more bank lending.

REVISION: Interplay between Accounting and Prudential Regulation
Date Posted:Thu, 14 Apr 2022 11:18:36 -0500
We develop a model in which accounting information and prudential regulation interact to affect banks' incentives to originate loans. Prudential regulators impose capital requirements to prevent banks from taking excessive risk. However, regulators cannot commit to ex-ante efficient intervention and, instead, respond to ex-post accounting information. We show that capital requirements and accounting measurement are substitutes when considered separately. By contrast, when considered jointly, accounting measurement and capital requirements are complementary tools that affect the level and efficiency of credit decisions. Comparative statics link capital requirements, quality of accounting information, and regulatory intervention to credit market conditions. An upshot of our analysis is that by appropriately optimizing the information from expected loss models, prudential regulators may design looser capital requirements to spur more bank lending.

Asset Transfer Measurement Rules
Date Posted:Fri, 12 Feb 2021 13:17:55 -0600
We study the design of measurement rules when banks engage in loan transfers in secondary credit markets. Our model incorporates two standard frictions: 1) banks' monitoring incentives decrease in loan transfers, and 2) banks have private information about loan quality. Under only the monitoring friction, we find that the optimal measurement rule sets the same measurement precision regardless of bank characteristics, and strikes a balance between disciplining banks' monitoring efforts vs. facilitating efficient risk sharing. However, under both frictions, uniform measurement rules are no longer optimal but induce excessive retention, thus inhibiting efficient risk sharing. We show that the optimal measurement rule should be contingent on the amount of loan transfers. In particular, measurement decreases in the amount of loan transfers and no measurement should be allowed when banks have transferred most of their loans. We relate our results to current accounting standards for asset transfers.

REVISION: CECL: Timely Loan Loss Provisioning and Bank Regulation
Date Posted:Tue, 08 Sep 2020 09:04:45 -0500
We investigate how provisioning models affect bank regulation. We study an accuracy vs. timeliness trade-off between an incurred loss model (IL) and a current expected credit loss model (CECL). Relative to IL, CECL improves efficiency by enabling timely intervention to curb inefficient ex post asset-substitution even though the imprecise information of CECL entails false alarms. However, from a real effects perspective, our analysis uncovers a potential cost of CECL: banks respond to timely intervention by originating riskier loans so that timely intervention induces timelier risk-taking. By appropriately tailoring regulatory capital to information about credit losses, the regulator can improve the efficiency of CECL. In particular, we show that regulatory capital under CECL would be looser when early estimates of credit losses are sufficiently precise and/or risk-shifting incentives are not too severe. From a policy perspective, our analysis suggests that better coordination between ...

REVISION: Interplay between Accounting and Prudential Regulation
Date Posted:Wed, 02 Sep 2020 03:03:28 -0500
We develop a model in which accounting information and prudential regulation interact to affect banks' incentives to originate loans. Prudential regulators impose capital requirements on banks but cannot commit to ex-ante efficient intervention. Instead, they respond to ex-post accounting information. We show that accounting measurement and capital requirements are complementary tools that affect the level and efficiency of credit decisions. Comparative statics link capital requirement, quality of accounting information, and regulatory intervention to credit market conditions. An application is to the current debate on the expected loss provisioning model recently adopted in the financial industry.

REVISION: CECL: Timely Loan Loss Provisioning and Banking Regulation
Date Posted:Mon, 04 May 2020 03:28:57 -0500
We investigate how provisioning models affect bank regulation. We study an incurred loss model (IL) and a current expected credit loss model (CECL). Relative to IL, CECL improves efficiency as it allows for timely intervention to curb inefficient ex post asset-substitution. However, from a real effects perspective, our analysis uncovers a potential cost of CECL: banks respond to timely intervention by originating riskier loans so that timely intervention induce timelier risk-taking. By appropriately tailoring regulatory capital to information about credit losses, the regulator can improve the efficiency of CECL. In particular, we show that regulatory capital under CECL would be looser when early estimates of credit losses are sufficiently precise and/or risk-shifting incentives are not too severe. From a policy perspective, our model therefore calls for better coordination between bank regulators and accounting standard setters.

CECL: Timely Loan Loss Provisioning and Bank Regulation
Date Posted:Tue, 25 Feb 2020 19:50:24 -0600
We investigate how provisioning models affect bank regulation. We study an accuracy vs. timeliness trade-off between an incurred loss model (IL) and a current expected credit loss model (CECL). Relative to IL, CECL improves efficiency by enabling timely intervention to curb inefficient ex post asset-substitution even though the imprecise information of CECL entails false alarms. However, from a real effects perspective, our analysis uncovers a potential cost of CECL: banks respond to timely intervention by originating riskier loans so that timely intervention induces timelier risk-taking. By appropriately tailoring regulatory capital to information about credit losses, the regulator can improve the efficiency of CECL. In particular, we show that regulatory capital under CECL would be looser when early estimates of credit losses are sufficiently precise and/or risk-shifting incentives are not too severe. From a policy perspective, our analysis suggests that better coordination between standard setters and bank regulators could enable the latter to relax capital requirements in order to spur lending.

REVISION: CECL: Timely Loan Loss Provisioning and Banking Regulation
Date Posted:Tue, 25 Feb 2020 09:50:44 -0600
We investigate how loan loss models affect banking regulation. We study an incurred loss model (IL) and a current expected credit loss model (CECL). Relative to IL, CECL improves efficiency as it allows for timely intervention to curb inefficient ex post asset-substitution. However, from a real effects perspective, our analysis uncovers a potential cost of CECL: banks respond to timely intervention by originating riskier loans so that timely intervention induces timelier risk-taking. By appropriately tailoring regulatory capital to information about credit losses, the regulator can improve the efficiency of CECL. In particular, we show that regulatory capital under CECL would be looser when early estimates of credit losses are sufficiently precise and/or asset-substitution incentives are not too severe. From a policy perspective, our model therefore calls for better coordination between banking regulators and accounting standard setters.

Agency Conflicts, Bank Capital Regulation, and Marking-to-Market
Date Posted:Mon, 25 Mar 2019 20:10:53 -0500
We show how shareholder-debtholder agency conflicts interact with strategic reporting under asymmetric information to influence bank regulation. Relative to a benchmark unregulated economy, higher capital requirements mitigate inefficient asset substitution, but potentially exacerbate under investment due to debt overhang. The optimal regulatory policy balances distortions created by agency conflicts and asymmetric information, while incorporating the social benefit of bank debt. Asymmetric information and strategic reporting only impact regulation for intermediate social debt benefit levels. For lower social debt benefits in this interval, regulatory capital requirements are insensitive to accounting reports so bank balance sheets need not be marked to market to implement the optimal regulatory policy. For higher social debt benefits, however, capital requirements are sensitive to accounting reports, thereby necessitating mark-to-market accounting to implement bank regulation. Mark-to-market accounting is essential when bank leverage levels are high, and is more likely to be necessary as banks' asset risk or specificity increases.

New: Agency Conflicts, Bank Capital Regulation, and Marking-to-Market
Date Posted:Mon, 25 Mar 2019 11:12:07 -0500
We show how shareholder-debtholder agency conflicts interact with strategic reporting under asymmetric information to influence bank regulation. Relative to a benchmark unregulated economy, higher capital requirements mitigate inefficient asset substitution, but potentially exacerbate under investment due to debt overhang. The optimal regulatory policy balances distortions created by agency conflicts and asymmetric information, while incorporating the social benefit of bank debt. Asymmetric information and strategic reporting only impact regulation for intermediate social debt benefit levels. For lower social debt benefits in this interval, regulatory capital requirements are insensitive to accounting reports so bank balance sheets need not be marked to market to implement the optimal regulatory policy. For higher social debt benefits, however, capital requirements are sensitive to accounting reports, thereby necessitating mark-to-market accounting to implement bank regulation. ...

REVISION: Accounting versus Prudential Regulation
Date Posted:Sat, 01 Dec 2018 09:52:21 -0600
We develop a model to study how accounting and prudential regulations interact to affect banks' incentives to originate safe loans. Prudential regulators impose prudential limits on bank leverage but cannot commit to ex-ante efficient intervention, responding ex-post to accounting information. Our main result is that accounting measurement and capital requirements are tools best used in tandem. We demonstrate how suitably designed measurements can help ease credit and we derive various comparative statics linking bank leverage, quality of accounting information, and regulatory intervention. An application of our analysis is on the current debate on the expected loss provisioning model recently adopted in the financial industry.

Interplay between Accounting and Prudential Regulation
Date Posted:Tue, 13 Nov 2018 03:41:54 -0600
We develop a model in which accounting information and prudential regulation interact to affect banks' incentives to originate loans. Prudential regulators impose capital requirements to prevent banks from taking excessive risk. However, regulators cannot commit to ex-ante efficient intervention and, instead, respond to ex-post accounting information. We show that capital requirements and accounting measurement are substitutes when considered separately. By contrast, when considered jointly, accounting measurement and capital requirements are complementary tools that affect the level and efficiency of credit decisions. Comparative statics link capital requirements, quality of accounting information, and regulatory intervention to credit market conditions. An upshot of our analysis is that by appropriately optimizing the information from expected loss models, prudential regulators may design looser capital requirements to spur more bank lending.

REVISION: Accounting versus Prudential Regulation
Date Posted:Mon, 12 Nov 2018 17:41:55 -0600
We develop a model to study how accounting and prudential regulations interact to affect banks' incentives to originate safe loans. Prudential regulators impose prudential limits on bank leverage but cannot commit to ex-ante efficient intervention, responding ex-post to accounting information. Our main result is that accounting measurement and capital requirements are tools best used in tandem. We demonstrate how suitably designed measurements can help ease credit and we derive various comparative statics linking bank leverage, quality of accounting information, and regulatory intervention. An application of our analysis is on the current debate on the expected loss provisioning model recently adopted in the financial industry.

Agency Conflicts, Bank Capital Regulation and Accounting Measurement
Date Posted:Fri, 16 Dec 2016 14:12:48 -0600
We develop a model to show how shareholder-creditor agency conflicts interact with accounting measurement rules to influence the design of bank capital regulation. Relative to a benchmark autarkic regime, higher capital requirements mitigate inefficient asset substitution, but exacerbate underinvestment due to debt overhang. The optimal regulatory policy balances the distortions created by underinvestment and asset substitution, while also incorporating the excess cost of equity relative to debt financing for banks. The optimal regulatory policy can be implemented using historical cost accounting for low values of the excess cost of equity. For intermediate levels of the excess cost of equity, fair value accounting is necessary for regulation to optimally respond to interim performance signals by imposing higher capital requirements that mitigate asset substitution. If the excess cost of equity is sufficiently high, however, the optimal regulatory policy features forbearance by permitting asset substitution to mitigate underinvestment. Overall, our results highlight the importance of accounting measurement in influencing the design of bank regulation through the implementation of capital requirements.

New: Agency Conflicts, Bank Capital Regulation and Accounting Measurement
Date Posted:Fri, 16 Dec 2016 04:12:49 -0600
We develop a model to show how shareholder-creditor agency conflicts interact with accounting measurement rules to influence the design of bank capital regulation. Relative to a benchmark autarkic regime, higher capital requirements mitigate inefficient asset substitution, but exacerbate underinvestment due to debt overhang. The optimal regulatory policy balances the distortions created by underinvestment and asset substitution, while also incorporating the excess cost of equity relative to debt financing for banks. The optimal regulatory policy can be implemented using historical cost accounting for low values of the excess cost of equity. For intermediate levels of the excess cost of equity, fair value accounting is necessary for regulation to optimally respond to interim performance signals by imposing higher capital requirements that mitigate asset substitution. If the excess cost of equity is sufficiently high, however, the optimal regulatory policy features forbearance by ...

A Real Effects Perspective to Accounting Measurement and Disclosure: Implications and Insights for Future Research
Date Posted:Fri, 15 Jul 2016 16:16:46 -0500
Accounting measurement and disclosure rules have a significant impact on the real decisions that firms make. In this essay, we provide an analytical framework to illustrate how such real effects arise. Using this framework, we examine three specific measurement issues that remain controversial: (1) How does the measurement of investments affect a firm's investment efficiency? (2) How does the measurement and disclosure of a firm's derivative transactions affect a firm's choice of intrinsic risk exposures, risk management strategy, and the incentive to speculate? (3) How could marking-to-market the asset portfolios of financial institutions generate procyclical real effects? We draw upon these real effects studies to generate sharper and novel insights that we believe are useful not only for the development of accounting standards, but also for guiding future empirical research.

New: A Real Effects Perspective to Accounting Measurement and Disclosure: Implications and Insights for Future Research
Date Posted:Fri, 15 Jul 2016 07:16:46 -0500
Accounting measurement and disclosure rules have a significant impact on the real decisions that firms make. In this essay, we provide an analytical framework to illustrate how such real effects arise. Using this framework, we examine three specific measurement issues that remain controversial: (1) How does the measurement of investments affect a firm's investment efficiency? (2) How does the measurement and disclosure of a firm's derivative transactions affect a firm's choice of intrinsic risk exposures, risk management strategy, and the incentive to speculate? (3) How could marking-to-market the asset portfolios of financial institutions generate procyclical real effects? We draw upon these real effects studies to generate sharper and novel insights that we believe are useful not only for the development of accounting standards, but also for guiding future empirical research.

New: A Real Effects Perspective to Accounting Measurement and Disclosure: Implications and Insights for Future Research
Date Posted:Fri, 15 Jul 2016 07:15:39 -0500
Accounting measurement and disclosure rules have a significant impact on the real decisions that firms make. In this essay, we provide an analytical framework to illustrate how such real effects arise. Using this framework, we examine three specific measurement issues that remain controversial: (1) How does the measurement of investments affect a firm's investment efficiency? (2) How does the measurement and disclosure of a firm's derivative transactions affect a firm's choice of intrinsic risk exposures, risk management strategy, and the incentive to speculate? (3) How could marking-to-market the asset portfolios of financial institutions generate procyclical real effects? We draw upon these real effects studies to generate sharper and novel insights that we believe are useful not only for the development of accounting standards, but also for guiding future empirical research.

A Real Effects Perspective to Accounting Measurement and Disclosure: Implications and Insights for Future Research
Date Posted:Sun, 24 Jan 2016 20:17:20 -0600
Accounting measurement and disclosure rules have a significant impact on the real decisions that firms make. In this essay, we provide an analytical framework to illustrate how such real effects arise. Using this framework, we examine three specific measurement issues that remain controversial: (1) How does the measurement of investments affect a firm?s investment efficiency? (2) How does the measurement and disclosure of a firm?s derivative transactions affect a firm?s choice of intrinsic risk exposures, risk management strategy, and the incentive to speculate? (3) How marking-to-market the asset portfolios of financial institutions could generate pro-cyclical real effects? We draw upon these real effects studies to generate sharper and novel insights that we believe are useful not only for the development of accounting standards but also for guiding future empirical research.

New: A Real Effects Perspective to Accounting Measurement and Disclosure: Implications and Insights for Future Research
Date Posted:Sun, 24 Jan 2016 10:17:20 -0600
Accounting measurement and disclosure rules have a significant impact on the real decisions that firms make. In this essay, we provide an analytical framework to illustrate how such real effects arise. Using this framework, we examine three specific measurement issues that remain controversial: (1) How does the measurement of investments affect a firm’s investment efficiency? (2) How does the measurement and disclosure of a firm’s derivative transactions affect a firm’s choice of intrinsic risk exposures, risk management strategy, and the incentive to speculate? (3) How marking-to-market the asset portfolios of financial institutions could generate pro-cyclical real effects? We draw upon these real effects studies to generate sharper and novel insights that we believe are useful not only for the development of accounting standards but also for guiding future empirical research.

How Frequent Financial Reporting Can Cause Managerial Short-Termism: An Analysis of the Costs and Benefits of Increasing Reporting Frequency
Date Posted:Thu, 11 Sep 2014 06:58:10 -0500
We develop a cost-benefit tradeoff that provides new insights into the frequency with which firms should be required to report the results of their operations to the capital market. The benefit to increasing the frequency of financial reporting is that it causes market prices to better deter investments in negative net present value projects. The cost of increased frequency is that it increases the probability of inducing managerial short-termism. We analyze the tradeoff between these costs and benefits and develop conditions under which greater reporting frequency is desirable and conditions under which it is not.

New: How Frequent Financial Reporting Can Cause Managerial Short-Termism: An Analysis of the Costs and Benefits of Increasing Reporting Frequency
Date Posted:Wed, 10 Sep 2014 21:58:10 -0500
We develop a cost-benefit tradeoff that provides new insights into the frequency with which firms should be required to report the results of their operations to the capital market. The benefit to increasing the frequency of financial reporting is that it causes market prices to better deter investments in negative net present value projects. The cost of increased frequency is that it increases the probability of inducing managerial short-termism. We analyze the tradeoff between these costs and benefits and develop conditions under which greater reporting frequency is desirable and conditions under which it is not.

REVISION: How Frequent Financial Reporting Can Cause Managerial Short-Termism: An Analysis of the Costs and Benefits of Increasing Reporting Frequency
Date Posted:Thu, 23 Jan 2014 01:39:48 -0600
We develop a cost-benefit tradeoff that provides new insights into the frequency with which firms should be required to report the results of their operations to the capital market. The benefit to increasing the frequency of financial reporting is that it causes market prices to better deter investments in negative net present value projects. The cost of increased frequency is that it increases the probability of inducing managerial short-termism. We analyze the tradeoff between these costs and benefits and develop conditions under which greater reporting frequency is desirable and conditions under which it is not.

Should Banks' Stress Test Results Be Disclosed? An Analysis of the Costs and Benefits
Date Posted:Sun, 15 Dec 2013 17:57:52 -0600
Stress tests have become an important component of the supervisory toolkit. However, the extent of disclosure of stress-test results remains controversial. We argue that while stress tests uncover unique information to outsiders ? because banks operate in second-best environments with multiple imperfections ? there are potential endogenous costs associated with such disclosure. First, disclosure might interfere with the operation of the interbank market and the risk sharing provided in this market. Second, while disclosure might improve price efficiency and hence market discipline, it might also induce sub-optimal behavior in banks. Third, disclosure might induce ex post market externalities that lead to excessive and inefficient reaction to public news. Fourth, disclosure might also reduce traders incentives to gather information, which reduces market discipline because it hampers the ability of supervisors to learn from market data for their regulatory actions. Overall, we believe that disclosure of stress-test results is beneficial because it promotes financial stability. However, in promoting financial stability, such disclosures may exacerbate bank-specific inefficiencies. We provide some guidance on how such inefficiencies could be minimized.

New: Should Banks' Stress Test Results Be Disclosed? An Analysis of the Costs and Benefits
Date Posted:Sun, 15 Dec 2013 07:57:52 -0600
Stress tests have become an important component of the supervisory toolkit. However, the extent of disclosure of stress-test results remains controversial. We argue that while stress tests uncover unique information to outsiders – because banks operate in second-best environments with multiple imperfections – there are potential endogenous costs associated with such disclosure. First, disclosure might interfere with the operation of the interbank market and the risk sharing provided in this market. Second, while disclosure might improve price efficiency and hence market discipline, it might also induce sub-optimal behavior in banks. Third, disclosure might induce ex post market externalities that lead to excessive and inefficient reaction to public news. Fourth, disclosure might also reduce traders incentives to gather information, which reduces market discipline because it hampers the ability of supervisors to learn from market data for their regulatory actions. Overall, we ...

REVISION: Corporate Governance and Innovation: Theory and Evidence
Date Posted:Wed, 27 Feb 2013 19:12:25 -0600
We develop a theory to show how external and internal corporate governance mechanisms affect innovation. We show that there is a U-shaped relation between innovation and external takeover pressure, which arises from the interaction between expected takeover premia and private benefits of control. We show strong empirical support for the predicted relation using ex ante and ex post innovation measures. We exploit the variation in takeover pressure created by the passage of anti-takeover laws ...

Corporate Governance and Innovation: Theory and Evidence
Date Posted:Sun, 03 Feb 2013 15:33:14 -0600
We develop a theory to show how external and internal corporate governance mechanisms affect innovation. We show that there is a U-shaped relation between innovation and external takeover pressure, which arises from the interaction between expected takeover premia and private benefits of control. We show strong empirical support for the predicted relation using ex ante and ex post innovation measures. We exploit the variation in takeover pressure created by the passage of anti-takeover laws across different states. Innovation is fostered either by an unhindered market for corporate control, or by anti-takeover laws that are severe enough to effectively deter takeovers.

REVISION: Corporate Governance and Innovation: Theory and Evidence
Date Posted:Sun, 03 Feb 2013 10:33:14 -0600
We develop a theory to show how external and internal corporate governance mechanisms affect innovation. We show that there is a U-shaped relation between innovation and external takeover pressure, which arises from the interaction between expected takeover premia and private benefits of control. We show strong empirical support for the predicted relation using ex ante and ex post innovation measures. We exploit the variation in takeover pressure created by the passage of anti-takeover laws ...

REVISION: How Frequent Financial Reporting Causes Managerial Short-Termism: An Analysis of the Costs and Benef
Date Posted:Sat, 05 Jan 2013 05:49:49 -0600
We investigate the costs and benefits associated with the frequency of financial reporting. We show that more frequent reporting results in price pressures that cause managerial short-termism. On the other hand, more frequent reporting provides increased discipline on the incentive to undertake negative net present value projects. We develop condition under which greater frequency of reporting is dysfunctional even though such reporting provides incremental information to the capital market.

How Frequent Financial Reporting Can Cause Managerial Short-Termism: An Analysis of the Costs and Benefits of Increasing Reporting Frequency
Date Posted:Thu, 03 Jan 2013 18:24:35 -0600
We develop a cost-benefit tradeoff that provides new insights into the frequency with which firms should be required to report the results of their operations to the capital market. The benefit to increasing the frequency of financial reporting is that it causes market prices to better deter investments in negative net present value projects. The cost of increased frequency is that it increases the probability of inducing managerial short-termism. We analyze the tradeoff between these costs and benefits and develop conditions under which greater reporting frequency is desirable and conditions under which it is not.

REVISION: How Frequent Financial Reporting Causes Managerial Short-Termism: An Analysis of the Costs and Benef
Date Posted:Thu, 03 Jan 2013 13:24:35 -0600
We develop an economic model to study the costs and benefits of increasing the frequency of mandatory reporting. We show that the benefit from increasing the frequency of financial reporting is that it provides better ex ante incentives for investment. The cost of increased frequency is that it increases the probability of inducing managerial short termism. We tradeoff these costs and benefits and develop conditions under which greater reporting frequency is desirable and conditions under ...

REVISION: Corporate Governance and Innovation: Theory and Evidence
Date Posted:Sun, 08 Jul 2012 15:05:45 -0500
We develop a theory to show how external corporate governance mechanisms, such as the market for corporate control, and internal governance mechanisms interact to affect innovation by ?firms. Our model generates the novel testable implication that there is a non-monotonic U-shaped relation between the degree of innovation undertaken by ?firms and the external takeover pressure they face. The U-shaped relation arises from the incentive effects of the interaction between expected takeover ...

REVISION: Corporate Governance and Innovation: Theory and Evidence
Date Posted:Mon, 21 Feb 2011 17:13:00 -0600
We develop a theory of the impact of external and internal corporate governance mechanisms on innovation by firms. Our model generates the novel testable implication that there is a non-monotonic U-shaped relation between the degree of innovation undertaken by firms and the external takeover pressure they face. The U-shaped relation arises from the incentive effects of the interaction between expected takeover premia and private benefits of control. We show strong empirical support for the ...

New: Agency Conflicts, Prudential Regulation, and Marking to Market
Date Posted:Thu, 13 Jan 2011 04:51:12 -0600
We develop a theory of how agency conflicts between the shareholders and debt holders of a financial institution, accounting measurement rules, and prudential capital regulation interact to affect the institution’s capital structure and project choices. We show that, relative to a benchmark historical cost regime in which assets and liabilities on the institution’s balance sheet are measured at their origination values, fair value or mark-to-market accounting could mitigate asset substitution, ...

Agency Conflicts, Prudential Regulation, and Marking to Market
Date Posted:Thu, 13 Jan 2011 00:00:00 -0600
We develop a theory of how agency conflicts between the shareholders and debt holders of a financial institution, accounting measurement rules, and prudential capital regulation interact to affect the institution?s capital structure and project choices. We show that, relative to a benchmark historical cost regime in which assets and liabilities on the institution?s balance sheet are measured at their origination values, fair value or mark-to-market accounting could mitigate asset substitution, but exacerbate under-investment arising from debt overhang. The optimal choices of the accounting regime and the prudential solvency constraint balance the inefficiencies due to asset substitution and under-investment that move in opposing directions. Under fair value accounting, the optimal (value-maximizing) solvency constraint declines with the institution?s marginal cost of investment in project quality, and with the excess cost of equity capital relative to debt capital. Fair value accounting dominates historical cost accounting provided the solvency constraints in the respective regimes take their optimal values. If the solvency constraint in the fair value regime is sub-optimally set to be too tight, however, historical cost accounting dominates fair value accounting.

REVISION: The Economic Trade-Offs in the Fair Value Debate
Date Posted:Sat, 27 Mar 2010 04:22:20 -0500
In this paper, I provide two general insights that are useful in evaluating the economic trade-offs of alternative accounting measurement rules. First, when there are multiple imperfections in the world, restricting a strict subset of it need not always improve welfare. Second, a firm is not a black box that operates independently of the measurement environment. Measuring a firm’s operations affects the firm’s actions which, in turn, affect the underlying distribution of cash flows that is ...

REVISION: Corporate Governance and Innovation: Theory and Evidence
Date Posted:Mon, 05 Oct 2009 10:11:37 -0500
We develop a theory of the effects of external and internal corporate governance mechanisms on innovation. Our theory generates the following testable predictions: (i) innovation varies non-monotonically in a U-shaped manner with takeover pressure; (ii) innovation increases with monitoring intensity; and (iii) the sensitivity of innovation to changes in takeover pressure declines with monitoring intensity. We show strong empirical support for these predictions using both ex ante and ex post ...

REVISION: What are the Economic Trade-Offs in the Fair Value Debate?
Date Posted:Fri, 02 Oct 2009 15:13:09 -0500
In this paper, I provide two general insights that are useful in evaluating the economic trade-offs of alternative accounting measurement rules. First, when there are multiple imperfections in the world, restricting a strict subset of it need not always improve welfare. Second, a firm is not a black box that operates independently of the measurement environment. Measuring a firm’s operations affects the firm’s actions which, in turn, affect the underlying distribution of cash flows that is ...

The Economic Trade-Offs in the Fair Value Debate
Date Posted:Fri, 02 Oct 2009 00:00:00 -0500
In this paper, I provide two general insights that are useful in evaluating the economic trade-offs of alternative accounting measurement rules. First, when there are multiple imperfections in the world, restricting a strict subset of it need not always improve welfare. Second, a firm is not a black box that operates independently of the measurement environment. Measuring a firm?s operations affects the firm?s actions which, in turn, affect the underlying distribution of cash flows that is being measured. Using these two insights, I discuss the economic consequences of accounting measurement rules that strive for greater transparency. In particular, I focus on the costs and benefits of fair value accounting and its implications for financial stability.

Should Intangibles be Measured: What are the Economic Trade-Offs?
Date Posted:Tue, 26 May 2009 08:38:34 -0500
We investigate whether a firm's intangible investments should be measured and separated from operating expenses. We find that the information extracted from accounting reports of investments and earnings is different when intangibles are measured and identified separately from operating expenses than when intangibles are left commingled with operating expenses. This difference in the market's information causes a change in the behavior of market prices, inducing changes in the firm's ...

Accounting Conservatism and the Efficiency of Debt Contracts
Date Posted:Wed, 06 May 2009 00:00:00 -0500
In this paper we examine whether accounting conservatism facilitates or detracts from the efficiency of debt contracting. We consider both unconditional and conditional conservatism as discussed in the literature. In both cases, our analysis does not support the positive relationship between accounting conservatism and the efficiency of debt contracting, as suggested by Watts [2003], and as hypothesized in numerous empirical studies. In fact, we find the opposite can be true. Under very plausible conditions, we find that accounting conservatism, that affects the information content of accounting reports, actually decreases the efficiency of debt contracts. Our notion of efficiency is derived endogenously from the joint optimality of the debt covenant and the corresponding interest rate on debt, but differs from the usual efficiency notion assumed in empirical studies. We also develop and use a statistical characterization of conservatism that is new in the literature but which, we believe, is consistent with the widely accepted definition of accounting conservatism originally proposed by Basu [1997].

New: Accounting Conservatism and the Efficiency of Debt Contracts
Date Posted:Tue, 05 May 2009 19:29:48 -0500
In this paper we examine whether accounting conservatism facilitates or detracts from the efficiency of debt contracting. We consider both “unconditional” and “conditional” conservatism as discussed in the literature. In both cases, our analysis does not support the positive relationship between accounting conservatism and the efficiency of debt contracting, as suggested by Watts [2003], and as hypothesized in numerous empirical studies.1 In fact, we find the opposite can be true. Under very ...

REVISION: Corporate Governance and Innovation: Theory and Evidence
Date Posted:Thu, 09 Apr 2009 10:02:49 -0500
We develop a theory of the effects of external corporate governance mechanisms - such as takeover pressure - and internal mechanisms - such as compensation contracts and monitoring intensity - on innovation. Our theory generates the following testable predictions: (i) innovation varies non-monotonically in a U-shaped manner with takeover pressure; (ii) innovation increases with monitoring intensity; and (iii) the sensitivity of innovation to changes in takeover pressure declines with ...

REVISION: Corporate Governance and Innovation: Theory and Evidence
Date Posted:Wed, 08 Apr 2009 09:51:12 -0500
We develop a theory of the effects of external corporate governance mechanisms - such as takeover pressure - and internal mechanisms - such as compensation contracts and monitoring intensity - on innovation. Our theory generates the following testable predictions: (i) innovation varies non-monotonically in a U-shaped manner with takeover pressure; (ii) innovation increases with monitoring intensity; and (iii) the sensitivity of innovation to changes in takeover pressure declines with ...

REVISION: Corporate Governance and Innovation: Theory and Evidence
Date Posted:Tue, 24 Feb 2009 19:28:07 -0600
We develop a theory of the effects of external corporate governance mechanisms -- such as takeover pressure -- and internal mechanisms -- such as compensation contracts and monitoring intensity -- on innovation. Our theory generates the following testable predictions: (i) innovation varies non-monotonically in a U-shaped manner with takeover pressure; (ii) innovation increases with monitoring intensity; and (iii) the sensitivity of innovation to changes in takeover pressure declines with ...

REVISION: Auditor Conservatism and Investment Efficiency
Date Posted:Thu, 12 Feb 2009 20:41:39 -0600
We develop a theoretical framework to investigate (i) both the determinants and the consequences of auditor conservatism in a capital market setting and (ii) the implications of the Sarbanes-Oxley Act for auditor conservatism and investment efficiency. We derive the following results. First, by varying the mix of audit and nonaudit fees, companies with high business risk induce auditor conservatism while companies with low business risk induce auditor aggressiveness. Second, if auditor ...

REVISION: Auditor Conservatism and Investment Efficiency
Date Posted:Tue, 10 Feb 2009 16:59:25 -0600
We develop a theoretical framework to investigate (i) both the determinants and the consequences of auditor conservatism in a capital market setting and (ii) the implications of the Sarbanes-Oxley Act for auditor conservatism and investment efficiency. We derive the following results. First, by varying the mix of audit and nonaudit fees, companies with high business risk induce auditor conservatism while companies with low business risk induce auditor aggressiveness. Second, if auditor ...

REVISION: Accounting Conservatism and the Efficiency of Debt Contracts
Date Posted:Tue, 10 Feb 2009 16:57:47 -0600
In this paper we examine how accounting conservatism affects the efficiency of debt contracting. We develop the statistical and informational properties of accounting reports under varying degrees of conditional and unconditional accounting conservatism, consistent with Basu's [1987] description of differential verifiability standards. Optimal debt covenants and interest rates on debt are derived from a natural tension between debt holders and equity claimants. We show how optimal covenants ...

REVISION: Market Pressure, Control Rights, and Innovation
Date Posted:Tue, 10 Feb 2009 16:54:36 -0600
There has been significant controversy over the desirability of anti-takeover protection devices, such as poison pills and golden parachutes. These devices are usually viewed negatively because they are associated with entrenchment and insider rent extraction. This position, however, is subject to debate. Insider protection, for instance, has the advantage of transferring control to better-informed insiders. In fact, in this paper we show that insider protection can arise endogenously as ...

New: Fair Value Accounting and Financial Stability
Date Posted:Tue, 30 Sep 2008 17:47:25 -0500
Accounting is sometimes seen just as a veil leaving the economic fundamentals unaffected. Indeed, in the context of completely frictionless markets, where assets trade in fully liquid markets and there are no problems of perverse incentives, accounting would be irrelevant since reliable market prices would be readily available to all. Just as accounting is irrelevant in such a world, so would any talk of establishing and enforcing accounting standards. To state the proposition the other way ...

Fair Value Accounting and Financial Stability
Date Posted:Tue, 30 Sep 2008 00:00:00 -0500
Accounting is sometimes seen just as a veil leaving the economic fundamentals unaffected. Indeed, in the context of completely frictionless markets, where assets trade in fully liquid markets and there are no problems of perverse incentives, accounting would be irrelevant since reliable market prices would be readily available to all. Just as accounting is irrelevant in such a world, so would any talk of establishing and enforcing accounting standards. To state the proposition the other way round, accounting is relevant only because we live in an imperfect world, where markets are not always fully liquid and incentives may be distorted. In such an imperfect world, transaction prices may not be readily available. Even those prices that are available may not correspond to the hypothetical market prices that would prevail in frictionless perfect markets. Therefore, when we debate issues regarding accounting, it is important to be clear on the nature and consequences of the imperfections.

REVISION: Marking to Market: Panacea or Pandora's Box?
Date Posted:Tue, 05 Aug 2008 19:14:55 -0500
Financial institutions have been at the forefront of the debate on the controversial shift in international standards from historical cost accounting to mark-to-market accounting. We show that the trade-offs at stake in this debate are far from one-sided. While the historical cost regime leads to some inefficiencies, marking to market may lead to other types of inefficiencies by injecting artificial risk that degrades the information value of prices, and induces sub-optimal real decisions ...

REVISION: Do Accounting Measurement Regimes Matter? A Discussion of Mark-to-Market Accounting and Liquidity Pr
Date Posted:Tue, 05 Aug 2008 19:10:48 -0500
Using a model with banking and insurance sectors, Allen and Carletti show that marking-to-market interacts with liquidity pricing to exacerbate the likelihood of financial contagion between the two sectors. In this discussion, I lay out the main ingredients of their model and explain how they interact with liquidity pricing to generate financial contagion. I then discuss some limitations of their model and propose an interesting extension.

REVISION: Marking to Market: Panacea or Pandora's Box?
Date Posted:Wed, 30 Jul 2008 18:26:31 -0500
Financial institutions have been at the forefront of the debate on the controversial shift in international standards from historical cost accounting to mark-to-market accounting. We show that the trade-offs at stake in this debate are far from one-sided. While the historical cost regime leads to some inefficiencies, marking to market may lead to other types of inefficiencies by injecting artificial risk that degrades the information value of prices, and induces sub-optimal real decisions ...

New: Information Management and Valuation: An Experimental Investigation
Date Posted:Wed, 30 Jul 2008 18:22:09 -0500
We explore the management of information and the response of market prices to such information. Sellers may be uncertain of dividends. We examine whether sellers anticipate buyers' pricing behavior and whether buyers' prices reflect correct inferences of the disclosure strategy of sellers. Buyers' inferences and sellers' anticipation require implicit Bayesian updating in solving for the equilibrium decision strategies of sellers and pricing behavior of buyers. Because of traditional problems ...

REVISION: Do Accounting Measurement Regimes Matter? A Discussion of Mark-to-Market Accounting and Liquidity Pr
Date Posted:Wed, 30 Jul 2008 09:33:58 -0500
Using a model with banking and insurance sectors, Allen and Carletti show that marking-to-market interacts with liquidity pricing to exacerbate the likelihood of financial contagion between the two sectors. In this discussion, I lay out the main ingredients of their model and explain how they interact with liquidity pricing to generate financial contagion. I then discuss some limitations of their model and propose an interesting extension.

New: Marking to Market, Liquidity and Financial Stability
Date Posted:Wed, 30 Jul 2008 09:05:50 -0500
This paper explores the financial stability implications of mark-to-market accounting, in particular its tendency to amplify financial cycles and the "reach for yield". Market prices play a dual role. Not only do they serve as a signal of the underlying fundamentals and the actions taken by market participants, they also serve a certification role and thereby influence these actions. When actions affect prices, and prices affect actions, the loop thus created can generate amplified responses - ...

New: Hedge Disclosures, Futures Prices, and Production Distortions
Date Posted:Wed, 30 Jul 2008 07:22:09 -0500
In this paper, we identify social benefits to hedge accounting disclosures that have not previously been examined. We show that from the perspective of price efficiency in the futures market the key information that is provided by hedge accounting is information about firms' underlying risk exposures. Without this information, the futures price confounds information regarding firms' hedge-motivated trades with their speculative trades, making the futures price inefficient. Our model shows ...

New: Do Mandatory Hedge Disclosures Discourage or Encourage Excessive Speculation?
Date Posted:Wed, 30 Jul 2008 07:04:07 -0500
In order to shed some light on the desirability of hedge disclosures, I investigate the consequences of hedge disclosures on a firm's risk management strategy. Several major results emerge from this analysis. First, greater transparency about a firm's derivative activities is not necessarily a panacea for imprudent risk management strategies. I show that such transparency actually induces the firm to take excessive speculative positions in the derivative market. Second, I show that the firm ...

Information Management and Valuation: An Experimental Investigation
Date Posted:Wed, 30 Jul 2008 00:00:00 -0500
We explore the management of information and the response of market prices to such information. Sellers may be uncertain of dividends. We examine whether sellers anticipate buyers' pricing behavior and whether buyers' prices reflect correct inferences of the disclosure strategy of sellers. Buyers' inferences and sellers' anticipation require implicit Bayesian updating in solving for the equilibrium decision strategies of sellers and pricing behavior of buyers. Because of traditional problems in inducing Bayesian behavior we employ a manual technology. Our results show that if we split selling strategies into "information management" (sanitization), full disclosure, and randomization, then the information disclosed is consistent with sellers anticipating buyers' pricing functional. Furthermore, prices themselves are sensitive to the information environment (Full Certainty, Intermediate Certainty, and Low Certainty) in which information asymmetry is manipulated.

Hedge Disclosures, Futures Prices, and Production Distortions
Date Posted:Wed, 30 Jul 2008 00:00:00 -0500
In this paper, we identify social benefits to hedge accounting disclosures that have not previously been examined. We show that from the perspective of price efficiency in the futures market the key information that is provided by hedge accounting is information about firms' underlying risk exposures. Without this information, the futures price confounds information regarding firms' hedge-motivated trades with their speculative trades, making the futures price inefficient. Our model shows that an inefficient futures price causes significant externalities by distorting the production choices of an entire industry. In the presence of hedge disclosures, the futures price appropriately informs production decisions in the whole industry. In addition to distortion in production choices, we also investigate the effect of an inefficient futures price on the risk-sharing role of the futures market. We find that lack of appropriate information about hedge disclosures also distorts the risk-sharing role of the futures market, thereby resulting in an increase in risk premium embedded in the futures price. Using numerical calculations, we demonstrate that the magnitude of the distortions in expected industry output can be substantial.

Do Mandatory Hedge Disclosures Discourage or Encourage Excessive Speculation?
Date Posted:Wed, 30 Jul 2008 00:00:00 -0500
In order to shed some light on the desirability of hedge disclosures, I investigate the consequences of hedge disclosures on a firm's risk management strategy. Several major results emerge from this analysis. First, greater transparency about a firm's derivative activities is not necessarily a panacea for imprudent risk management strategies. I show that such transparency actually induces the firm to take excessive speculative positions in the derivative market. Second, I show that the firm may choose a prudent risk management strategy in the absence of hedge disclosures. However, the selection of a prudent risk management comes at a cost. The firm's production policy is distorted in the absence of hedge disclosures. These findings suggest that the FASB must carefully investigate the trade-offs between production distortions and risk management distortions in evaluating the desirability of mandatory hedge disclosures for all firms.

Do Accounting Measurement Regimes Matter? A Discussion of Mark-to-Market Accounting and Liquidity Pricing
Date Posted:Wed, 30 Jul 2008 00:00:00 -0500
Using a model with banking and insurance sectors, Allen and Carletti show that marking-to-market interacts with liquidity pricing to exacerbate the likelihood of financial contagion between the two sectors. In this discussion, I lay out the main ingredients of their model and explain how they interact with liquidity pricing to generate financial contagion. I then discuss some limitations of their model and propose an interesting extension.

Marking to Market, Liquidity and Financial Stability
Date Posted:Wed, 30 Jul 2008 00:00:00 -0500
This paper explores the financial stability implications of mark-to-market accounting, in particular its tendency to amplify financial cycles and the "reach for yield". Market prices play a dual role. Not only do they serve as a signal of the underlying fundamentals and the actions taken by market participants, they also serve a certification role and thereby influence these actions. When actions affect prices, and prices affect actions, the loop thus created can generate amplified responses - both in creating bubble-like booms in asset prices, and also in magnifying distress episodes in downturns.

Marking to Market: Panacea or Pandora's Box?
Date Posted:Wed, 30 Jul 2008 00:00:00 -0500
Financial institutions have been at the forefront of the debate on the controversial shift in international standards from historical cost accounting to mark-to-market accounting. We show that the trade-offs at stake in this debate are far from one-sided. While the historical cost regime leads to some inefficiencies, marking to market may lead to other types of inefficiencies by injecting artificial risk that degrades the information value of prices, and induces sub-optimal real decisions. We construct a framework that can weigh the pros and cons. We find that the damage done by marking to market is greatest when claims are (i) long-lived, (ii) illiquid, and (iii) senior. These are precisely the attributes of the key balance sheet items of banks and insurance companies. Our results therefore shed light on why banks and insurance companies have been the most vocal opponents of the shift to marking to market.

REVISION: Corporate Governance and Innovation: Theory and Evidence
Date Posted:Wed, 23 Jul 2008 21:33:07 -0500
We develop a theory of the effects of external corporate governance mechanisms such as takeover pressure and internal mechanisms such as compensation contracts and monitoring intensity on innovation by firms. Our theory models a manager¿s choice between a routine and an innovative project. The innovative project differs from the routine project along two dimensions: (i) it has a higher risk-return trade-off and (ii) it possesses greater uncertainty about its quality. Our model predicts that: ...

REVISION: Auditor Conservatism and Investment Efficiency
Date Posted:Thu, 17 Jul 2008 17:23:45 -0500
We develop a theoretical framework to investigate (i) both the determinants and the consequences of auditor conservatism in a capital market setting and (ii) the implications of the Sarbanes-Oxley Act for auditor conservatism and investment efficiency. We derive the following results. First, by varying the mix of audit and nonaudit fees, companies with high business risk induce auditor conservatism while companies with low business risk induce auditor aggressiveness. Second, if auditor ...

New: Do Derivatives Disclosures Impede Sound Risk Management?
Date Posted:Thu, 17 Jul 2008 13:40:43 -0500
We model an environment in which firms disclose only one side of a hedging transaction, namely the gain or loss on the forward. However, the firm cannot credibly disclose the other side of the hedging transaction, namely the underlying exposure that is being hedged. We show that because the firm cannot credibly communicate that the exposure from its underlying project is hedgeable, greater transparency in the firm's derivative activities distorts firms' hedging decisions. The nature of ...

REVISION: Accounting Conservatism and the Efficiency of Debt Contracts
Date Posted:Thu, 17 Jul 2008 10:23:33 -0500
In this paper we examine how accounting conservatism affects the efficiency of debt contracting. We develop the statistical and informational properties of accounting reports under varying degrees of conditional and unconditional accounting conservatism, consistent with Basu's [1987] description of differential verifiability standards. Optimal debt covenants and interest rates on debt are derived from a natural tension between debt holders and equity claimants. We show how optimal covenants ...

REVISION: Optimal Takeover Mechanisms and Innovation
Date Posted:Thu, 17 Jul 2008 10:18:32 -0500
There has been significant controversy over the desirability of anti-takeover protection devices, such as poison pills and golden parachutes. These devices are usually viewed negatively because they are associated with entrenchment and insider rent extraction. This position, however, is subject to debate. Insider protection, for instance, has the advantage of transferring control to better-informed insiders. In fact, in this paper we show that insider protection can arise endogenously as ...

Market Pressure, Control Rights, and Innovation
Date Posted:Thu, 17 Jul 2008 04:50:22 -0500
There has been significant controversy over the desirability of anti-takeover protection devices, such as poison pills and golden parachutes. These devices are usually viewed negatively because they are associated with entrenchment and insider rent extraction. This position, however, is subject to debate. Insider protection, for instance, has the advantage of transferring control to better-informed insiders. In fact, in this paper we show that insider protection can arise endogenously as an optimal contracting device. Our main result is that the optimality of insider protection depends crucially on the degree of innovation of the firm's activities, with insider protection being desirable only under significant innovation. For highly innovative projects, in particular, a takeover bid can be optimally rejected even when it offers a significant premium over the market price of the firm.

Accounting Conservatism and the Efficiency of Debt Contracts
Date Posted:Thu, 17 Jul 2008 00:00:00 -0500
In this paper we examine how accounting conservatism affects the efficiency of debt contracting. We develop the statistical and informational properties of accounting reports under varying degrees of conditional and unconditional accounting conservatism, consistent with Basu's [1987] description of differential verifiability standards. Optimal debt covenants and interest rates on debt are derived from a natural tension between debt holders and equity claimants. We show how optimal covenants vary with the degree of conservatism and we derive an efficiency metric that depends on the degree of conservatism. We find that accounting conservatism actually decreases the efficiency of debt contracts, contrary to the suggestions of Watts [2003] and contrary to the hypothesis in numerous empirical studies.

Do Derivatives Disclosures Impede Sound Risk Management?
Date Posted:Thu, 17 Jul 2008 00:00:00 -0500
We model an environment in which firms disclose only one side of a hedging transaction, namely the gain or loss on the forward. However, the firm cannot credibly disclose the other side of the hedging transaction, namely the underlying exposure that is being hedged. We show that because the firm cannot credibly communicate that the exposure from its underlying project is hedgeable, greater transparency in the firm's derivative activities distorts firms' hedging decisions. The nature of these distortions depend crucially on (i) firms' information quality about their project types and (ii) the market's prior beliefs about whether or not firms have hedgeable projects. For most reasonable levels of information quality, we find that instead of impeding risk management, derivative disclosures are likely to induce firms to engage in excessive speculation.

Auditor Conservatism and Investment Efficiency
Date Posted:Thu, 17 Jul 2008 00:00:00 -0500
We develop a theoretical framework to investigate (i) both the determinants and the consequences of auditor conservatism in a capital market setting and (ii) the implications of the Sarbanes-Oxley Act for auditor conservatism and investment efficiency. We derive the following results. First, by varying the mix of audit and nonaudit fees, companies with high business risk induce auditor conservatism while companies with low business risk induce auditor aggressiveness. Second, if auditor conservatism is in force, a greater client pressure on auditors (in the form of granting or withholding potential client business opportunities) improves audit quality and if auditor aggressiveness is in force, a greater client pressure on auditors impairs audit quality. Third, the nature of a firm's investment inefficiency (overinvestment or underinvestment) depends on its auditor's attestation (conservatism or aggressiveness). Fourth, our model sheds light on the potential effects of Section 201 of the Sarbanes-Oxley Act, which prohibits public companies from granting their auditors many types of nonaudit services. Overall, the above results are useful both for public policy making and for empirical research.

REVISION: Corporate Governance and Innovation: Theory and Evidence.
Date Posted:Wed, 26 Mar 2008 16:21:36 -0500
We develop a model to investigate how external corporate governance mechanisms such as takeover pressure and internal mechanisms such as monitoring intensity affect a firm's incentives to engage in innovation. The manager of the firm can either choose a routine project or an innovative project. The innovative project differs from the routine project along two dimensions: (1) it has a higher risk-return trade-off and (2) it possesses a higher quality uncertainty. If the assessed quality ...

Corporate Governance and Innovation: Theory and Evidence
Date Posted:Wed, 26 Mar 2008 10:23:12 -0500
We develop a theory to show how external corporate governance mechanisms, such as the market for corporate control, and internal governance mechanisms interact to affect innovation by ?firms. Our model generates the novel testable implication that there is a non-monotonic U-shaped relation between the degree of innovation undertaken by ?firms and the external takeover pressure they face. The U-shaped relation arises from the incentive effects of the interaction between expected takeover premia and private bene?fits of control both of which vary with the takeover pressure that the ?firm faces. In particular, the key characteristics of innovation that distinguish it from mere risk-taking play a central role in generating the U-shaped relation. We show strong empirical support for the predicted non-monotonic relation using both ex ante and ex post measures of innovation. Our empirical analysis exploits the cross-sectional as well as time-series variation in takeover pressure created by the sequential passage of anti-takeover laws across different states. Our results suggest that innovation is fostered either by an unhindered market for corporate control, or by anti-takeover laws that are severe enough to effectively deter takeovers.

Should Intangibles Be Measured: What are the Economic Trade-Offs?
Date Posted:Wed, 14 Jul 2004 00:00:00 -0500
We investigate whether a firm's intangible investments should be measured and separated from operating expenses. We find that the information extracted from accounting reports of investments and earnings is different when intangibles are measured and identified separately from operating expenses than when intangibles are left commingled with operating expenses. This difference in the market's information causes a change in the behavior of market prices, inducing changes in the firm's investments and cash flows. Thus, from a perspective, measuring intangibles is not unambiguously desirable. We identify the conditions under which providing information on intangibles may be desirable. This study also shows the inadequacy of statistical associations between accounting numbers and prices as a basis for evaluating the desirability of measuring intangible investments. We show that the measurement of intangibles alters the very distribution of cash flows about which the measurement regime is seeking to provide information.