This paper studies the allocational effects associated with the precision of accounting estimates when the precision of estimates is a choice variable for firms. One part of the paper considers the effects of the observability of precision choices. We show that, generally, making precision choices private increases firms' equilibrium precision choices and also, as a by-product, their equilibrium investment choices. We further show that, when firms' precision choices are private, there may be a "disclosure trap," in which, unless investors conjecture the owner has chosen an estimate with the highest possible precision, the owner will respond to investors' conjecture by choosing an estimate whose precision is higher than investors' conjecture. In a multifirm version of the model with endogenous investment, we show that the equilibrium investment by the firm increases in the precision of the firm's own estimate and decreases in the precisions of other firms' estimates. Finally, we show that, in a setting where the firm's initial owner sells his stake in the firm over the course of two periods, with disclosures of estimates of the firm's value occurring prior to each sale of shares, if the precisions of the estimates are public, the equilibrium precisions of the estimates increase over time when the owner sells a sufficiently large fraction of the firm in the first period, and otherwise the equilibrium precisions of estimates remain constant over time.

This paper demonstrates the existence of two different kinds of externalities induced by an auditor servicing multiple clients at the same time. First, we show that the capital market price for a client can increase in the number of qualified reports that his auditor issues to his other clients, thus producing a stock price externality. Second when the audit firm has limited wealth, an additional client can actually decrease the audit quality and increase the average likelihood of audit failure relative to a single-client setting because of reporting externalities. Our analysis also demonstrates how requiring a more effective audit oversight mechanism can actually produce unintended consequences such as an increased likelihood of audit failures.

In an agency setting where the agent must be compensated both to exert effort to produce a new project and to announce honestly when the new project has been produced, we show that Holmstrom's (1979) well-known "informativeness criterion" does not, by itself determine whether a variable is optimally incorporated into the agent's contract. What also matters is how "severe" the control problem is between the principal and the agent. We further show that the severity of the moral hazard problem also determines whether it is desirable for the principal to have the agent implement the project more often than warranted by first-best implementation considerations.

This paper studies how an accountant's method of aggregating information in a financial report is affected by differences in the reliability and relevance of components of the report. We study a firm that hires an accountant to produce a report that reveals information to investors regarding the returns to the firms past investments. In constructing the report, the accountant must combine information elicited from the firm's manager with other information directly observable to the accountant. The manager's information is assumed to be directly observable only by the manager and to be of superior quality to the other information available to the accountant. Reliability-relevance trade-offs arise because as the accountant places more weight on the manager's report, potentially more useful information gets included in the report, at the cost of encouraging the manager to distort his or her information to a greater extent. Capital market participants anticipate this behavior and price the firm accordingly. We show how the market's price response to the release of the firm's aggregate report, the efficiency of the firm's investment decisions, and the manager's incentives to manipulate the soft information under his or her control are all affected by - and affect - the aggregation procedure the accountant adopts. In addition, we identify a broad range of circumstances under which aggregated reports are strictly more efficient than disaggregated reports because aggregation tempers the manager's misreporting incentives. We also demonstrate that, as any given component of the aggregated accounting report becomes softer, the equilibrium level of the firm's investment diminishes and the market places greater weight on the remaining components of the report.

This paper studies when a firm will acquire additional information about a potential new project by consulting outsiders, when doing so runs the risk of reducing the value of implementing the project as a consequence of information leakage. The analysis evaluates the firm's information acquisition activities in both the presence and absence of moral hazard in project production.

This paper demonstrates that a firm's trade-offs between reporting good news to reduce the cost of capital and bad news to minimize proprietary costs can induce the firm's manager to provide truthful disclosures when the opposing effects balance each other. We also show that greater proprietary costs can make a firm's disclosures more credible, increase the frequency of voluntary disclosures, and improve the disclosing firm's welfare. Further, we find that potential shareholder litigation can interact with capital and product markets' influences to make voluntary disclosures more credible, but only under certain circumstances. For example, although product market competition can complement the capital market effects in inducing the manager to provide truthful disclosures, shareholder litigation cannot complement the capital market in the same way. Nevertheless, while shareholder litigation can never induce misreporting, a very strong product market influence can prompt a firm to underreport its true economic condition.

Capital market participants collectively may possess information about the valuation implications of a firm's change in strategy not known by the management of the firm proposing the change. This paper asks whether a firm's management can exploit the capital market's information in deciding either whether to proceed with a contemplated strategy change or whether to continue with a previously initiated strategy change. In the case of a proposed strategy change, it is shown that managers can extract the capital market's information by announcing the potential new strategy, and then conditioning the decision to implement the new strategy on the size of the market's price reaction to the announcement. Under this arrangement, it is shown that a necessary condition to implement all and only positive net present value changes is that managers proceed to implement some strategies that garner negative price reactions upon their announcement. In the case of deciding whether to continue with a previously implemented strategy change, it is shown that it may be optimal for the firm to predicate its abandonment/continuation decision on the magnitude of the costs it has already incurred. Thus, what looks like "sunk-cost" behavior may in fact be optimal.

A firm typically assigns multiple tasks it must perform to either internal employees or out-side vendors. This paper demonstrates the need to integrate a task assignment decision with the design of a managerial control system as each affects the other. An internal employee is distinguished from an outside supplier on four different informational dimensions: (i) at the time of contracting, the outside supplier has less information about the task environment more often than the internal employee; (ii) the principal observes the employee's information set more frequently than that of the supplier; (iii) the principal can exercise a greater control over information flow to the internal employee than to the outside supplier; and (iv) the principal may share the details of the outside supplier's contract with the internal employee but not vice versa. Under each of these four distinguishing dimensions, the principal is shown to outsource the upstream task and assign the downstream task to the internal employee more often than vice versa. Further, under the last two dimensions of the firm's boundary, the principal can eliminate inefficiencies arising from the agents' contracting with incomplete information by assigning the downstream task to the employee and not providing predecision information to him while assigning the upstream task to the supplier.

This paper shows through increasing disclosure requirements may induce firms to reduce their value-relevant disclosures. In the absence of segment reporting requirements, an incumbent firm may voluntarily disclose value-relevant information because it can use other, value-irrelevant, information to jam proprietary disclosures. However, when required to disclose segment data, the incumbent may aggregate proprietary information with other value-relevant information to deter entry by a rival. Hence, the firm does not disclose value-relevant information it would have revealed voluntarily in the absence of segment disclosure requirements. In such situations, requiring more disaggregate disclosures can actually decrease price efficiency.

The article looks at the interaction of financial reporting systems with contracting systems using a principal-agent model. Reporting discretion is determined in a trade-off between the financial reporting system and the contracting system as well as the owner's decision of what is optimal. Reporting of a firm's economic earnings is termed truthful reporting while reporting discretion is looked at as earnings management. The manager manipulates accruals and economic earnings. The principal-agent model deals with moral hazard over managerial reporting with the contracting system in order to discipline reporting behavior.

The article discusses the effects of a firm's voluntary disclosures on other firms. When Citibank reported the level of default on its Third World loans other banks followed with similar announcements. Following the write-off of Chambers Development for their waste disposal arrangements other waste management firms did the same. These disclosures were attempts to influence the financial market's assessment of the value of the firms rather than the product market behavior by management. Also, the disclosure dynamics of a firm's selection of a disclosure policy is related to its expected price.

In this paper, we demonstrate that informational asymmetries within a firm along with managerial labor market concerns can jointly result in investment myopia being equilibrium behavior. In contrast to earlier studies (like that of Shleifer and Vishny [1989]), we find that in the presence of both reputation and entrenchment incentives, managers invest in long-term projects for reputation building and short-term projects to entrench themselves. Further, we establish conditions under which delegating project selection is optimal, even though it requires that the owner tolerate short-term project selection. Finally, we present several empirical implications of our analysis.

Demonstrates how a manager's concern for reputation can distort reports made to superiors about an investment project and affect a firm's capital budgeting decisions. Managerial investment distortion in the choice between short term and long term projects; Underinvestment of the firm as a result of managerial misreporting; Participative budgeting issues.

This article shows that if all variables that determine a firm's future cash flows are not contractible, it can be ex ante optimal to design a financial contract that admits debtholders waiving debt covenants on a discretionary basis and firms investing opportunistically subsequent to contracting. Further, as the contractible variable becomes less informative, the contract attaches greater significance to it. Finally, uncertainty in the magnitude of reporting latitude induces aggressive reporting by the firm to avoid violating the covenant or to enhance the chances of a waiver. The debtholders respond by sometimes not allowing the firm to implement mutually beneficial projects.