Complexity of financial reporting standards and accounting expertise

This study tests whether firms seek to mitigate the adverse effects of Financial Reporting Complexity (FRC) by investing in accounting expertise. We develop a measure of FRC based on the complexity of accounting standards that govern annual disclosures. We find that FRC is positively related to the accounting expertise on a firm’s board of directors and audit committee. We also find that accounting expertise mitigates the relation between FRC and negative reporting outcomes. Collectively, this study increases our understanding of the actions firms take to mitigate the negative consequences of FRC, and the role of accounting expertise in this setting.     

Entrenchment and Severance Pay in Optimal Governance Structures

This paper explores how motivating an incumbent CEO to undertake actions that improve the effectiveness of his management interacts with the firm's policy on CEO replacement. Such policy depends on the presence and the size of severance pay in the CEO's compensation package and on the CEO's influence on the board of directors regarding his own replacement (i.e., entrenchment). We explain when and why the combination of some degree of entrenchment and a sizeable severance package is desirable. The analysis offers predictions about the correlation between entrenchment, severance pay, and incentive compensation.     

Specific knowledge and performance measurement

I examine optimal incentives and performance measurement in a model where an agent has specific knowledge (in the sense of Jensen and Meckling) about the consequences of his actions for the principal. Contracts can be based both on “input” measures related to the agent's actions and an “output” measure related to the principal's payoff. Whereas input‐based pay minimizes income risk, only output‐based pay encourages the agent to use his knowledge efficiently. In general, it is optimal to use both kinds of performance measures. The results help to explain some empirical puzzles and lead to several new predictions.     

Near-sighted Justice

Chapter 11 structures complex negotiations between creditors and debtors that are overseen by a bankruptcy court. We identify conditions where the court should sometimes err in determining which firms should be liquidated. Such errors affect actions by both good and bad entrepreneurs. We first characterize the optimal error rate without renegotiation. When creditors and debtors can renegotiate to circumvent an error‐riven court, for one class of actions a blind court that ignores all information is optimal. For another class, the court should place the burden of proof on the entrepreneur. The robust feature is that the court should sometimes err.     

Optimal Continuation versus the Timeless Perspective in Monetary Policy

The timeless‐perspective approach suggests that policymakers implement in each period policy actions conforming to a rule that would have been fully optimal to adopt in the distant past. A motivating advantage is that policy henceforth would continue by recommending the same optimality conditions if reconsidered, thereby enhancing credibility. We argue that continuation can alternatively be achieved with better results, on average, in terms of policymakers' objectives, by implementing in each period the time‐invariant policy that is optimal from the viewpoint of the contemporary understanding of objectives and constraints, but while ignoring the conditions that happen to prevail at the time.     

Efficient Manipulation in a Repeated Setting

We analyze the optimal behavior of an organization when its employees can manipulate the organization's accounting system to their private advantage. We find that the organization may benefit by helping its employees manipulate the system. This help can reduce the employees' private returns from devoting effort to further manipulation of the accounting system, which reduces the cost of motivating the employees to devote their effort to improving the real (rather than the measured) performance of the organization.     

Contracting with private knowledge of signal quality

We characterize the optimal procurement contract in a setting where a supplier has privileged knowledge of the quality of a public signal about his production costs. The optimal contract exhibits important differences with standard contracts in adverse selection settings. For instance, the contract induces output both above and below first‐best levels. Furthermore, the induced output may not vary with the realized public signal unless the signal quality is sufficiently pronounced. In addition, output may increase as expected costs increase.     

Accrual versus cash-basis accounting methods: An agency-theoretic comparison

In an agency setting with moral hazard, this paper analytically demonstrates that accrual accounting is superior to cash-basis accounting (subject to costs). The main reason is that accrual accounting information more fully reflects the overall effects of managerial actions or efforts on future cash flows than cash flow realizations in any given period. As a result, accrual accounting information is more efficient than cash-basis accounting information for both motivating managers to expend efforts and sharing risks under moral hazard.     

Costly state verification and multiple investors: the role of seniority

Many financial claims specify fixed maximum payments, varyingseniority, and absolute priority for more senior investors.These features are motivated in a model where a firm's managercontracts with several investors and firm output can only beverified privately at a cost. Debt-like contracts of varyingseniority generally dominate symmetric contracts, and, wheninvestors are risk neutral, it is optimal to use debt-like contractswhere more senior claims have absolute priority over more juniorclaims. In addition to motivating several features of debt andpreferred stock, the model offers an explanation for structuresused in leveraged buyouts, asset-backed securitizations, andreinsurance contracts.     

Causes and Consequences of Improvements in the Information Environment for Swedish Small and Mid-Sized Firms

We investigate improvements in the information environment and financing decisions for Swedish small and mid-sized firms. These firms are required to file audited annual reports. We create an index capturing accounting standards choices, auditor quality, and board size reflecting information environment improvements. We find an association between increased short-term financing and information environment improvements: The most common actions are to switch to a Big 4 auditor or a chartered accountant and to add independent board members as opposed to changing the accounting standards used. These improvements are associated with a switch to long-term debt and a reduction of cost of debt. Our findings are relevant for the ongoing discussion on accounting regulation for private firms both in the USA and Europe since they show that (Swedish) private firms use other ways to improve the information environment in order to access to less costly long-term bank debt besides adopting International Financial Reporting Standards.     

Wimp or tough guy: Sequential default risk and signaling with mortgages

When analyzing what to do with a currently defaulted loan, the lender must consider the impact of his foreclosure versus workout decision on the expected payoff of subsequent loans as well as on the payoff of the current loan. This is because borrowers with future loan payoff dates can observe the lender's actions and update prior information regarding the lender's toughness or wimpiness when dealing with defaulted loans. In this paper we consider the strategic interaction between a lender and multiple borrowers, where borrowers have distinct, sequentially maturing mortgage loans and where the lender has private information regarding the magnitude of his foreclosure costs. We find that a variety of strategic outcomes can occur that explain the co-existence of workout and foreclosure in the mortgage marketplace. In general, the lender's workout/foreclosure response depends on the cost of bluffing (e.g., foreclosing when workout is cheaper) versus the value of reducing expected defaults and workout concession losses on future loans (e.g., imperfect foreclosure cost information leads future borrowers to payoff the mortgage when default would have been optimal under perfect information). Given recently revised expectations regarding the depth of the real estate recession, our results may explain the move by many lenders away from granting workout concessions and toward taking a harder line when dealing with defaulting borrowers.     

Motivating Innovation

Motivating innovation is important in many incentive problems. This paper shows that the optimal innovation‐motivating incentive scheme exhibits substantial tolerance (or even reward) for early failure and reward for long‐term success. Moreover, commitment to a long‐term compensation plan, job security, and timely feedback on performance are essential to motivate innovation. In the context of managerial compensation, the optimal innovation‐motivating incentive scheme can be implemented via a combination of stock options with long vesting periods, option repricing, golden parachutes, and managerial entrenchment.     

Repeated lending under contractual incompleteness

We consider a model of repeated (relationship) lending in which some contingencies that are relevant for a bank’s decision to finance a project cannot be described contractually. The hazards related to this lack of contractibility can be magnified by actions taken by an entrepreneur. The continuation value of a lending relationship induces borrowers to take actions that minimize the ex-post conflict of interests resulting from contractual incompleteness. The optimal lending relationship is stationary on the equilibrium path. A robust feature of an optimal lending relationship is that the action schedule (as a function of project types) adopted by the entrepreneur is either a constant or a step function. Hence, the bank imposes to the entrepreneur a finite set of decisions from which he can pick his action, bounding his discretion over decisions. This leads to lower interest rates charged by the bank and to efficient refinancing in a lending relationship when compared to arm’s length financing.     

Procurement when price and quality matter

A buyer seeks to procure a good characterized by its price and its quality from suppliers who have private information about their cost structure (fixed cost and marginal cost of providing quality). We characterize the buyer's optimal buying mechanism. We then use the optimal mechanism as a theoretical and numerical benchmark to study simpler buying procedures such as scoring auctions and bargaining. Scoring auctions can extract a significant proportion of the buyer's strategic surplus (the difference between the expected utility from the optimal mechanism and the efficient auction). Bargaining does less well and often does worse than the efficient auction.     

Has Financial Regulation Been a Flop? (or How to Reform Dodd‐Frank)

Recent bank regulations have imposed large compliance costs on banks of all sizes, and have increased the costs of borrowing to both consumers and companies. But in this summary of his recent book, the author argues that the problems with banking system regulation go well beyond the excessive costs. Indeed, Dodd‐Frank and other post‐crisis regulatory reforms have failed to address the major shortcomings that produced the crisis of 2007–2009. Most importantly, excessive housing finance risk was not dealt with adequately, and is already on the rise again. And prudential standards for banks, while much stricter, remain unreliable in a severe economic downturn. After providing evidence of the shortcomings of major parts of the regulatory structure created after 2008, the author points to fundamental problems in the thinking underlying the post‐crisis regulatory changes that made those reforms unlikely to succeed. Moreover, he argues that the new processes of financial regulation have fostered many abuses of the rule of law, which have politicized regulation, adding to its cost and discrediting important supervisory and regulatory agencies. The author suggests that simpler, more effective, less costly, and more respectable approaches to regulation are possible. He offers a set of principles to guide reform and proposes over 20 specific actions that would enhance the effectiveness, reduce the costs, and improve the processes of bank regulation.     

Competition and cooperation among exchanges: A theory of cross-listing and endogenous listing standards

We analyze firms’ choice of exchange to list equity and exchanges’ choice of listing standards when insiders have private information about firm value, but outsiders can produce (noisy) information at a cost. Exchanges are populated by two kinds of investors, whose numbers vary across exchanges: sophisticated (low information production cost) investors and ordinary (high–cost) investors. While firms are short-lived, exchanges are long-lived, value-maximizing agents whose listing and disclosure standards evolve over time. The listing standards chosen by exchanges affect their “reputation,” since outsiders can partially infer the rigor of these standards from the post-listing performance of firms. We show that, while exchanges use their listing standards as a tool in competing for listings with other exchanges, this will not necessarily lead to a “race to the bottom” in listing standards. Further, a merger between two exchanges may result in a higher listing standard for the combined exchange relative to that of either of the merging exchanges. We develop several other implications for firms’ listing choices and resulting valuation effects, the impact of competition and co-operation among exchanges on listing standards, and the optimal regulation of exchanges.     

The role of expertise in risk communication: laypeople's and expert's perception of the millennium bug risk in The Netherlands

This paper focuses on the discussion of the role of expertise in risk communication. It describes empirical data on the risks posed by the Millennium bug in 1999 in the Netherlands. The study systematically examined the risk perception of both general public and computer experts with respect to the Millennium bug, assessing a potential discrepancy between the layman's and the expert's judgement, as has been observed in other risk areas. Two surveys were fielded, the first aimed at a random sample of the Dutch population ( n = 253), the second at a sample of computer experts ( n = 91). Results indicated that respondents did not perceive the Millennium bug to be a major threat. However, laypeople worried more, did see the issue as more personally risky, and did think the level of public awareness was higher than experts did. Computer experts felt more capable of taking mitigating actions than laypeople, and were more convinced that these actions were adequate. The implications of these findings for the role of expertise in risk communication are discussed.     

Claiming Strategies and Premium Levels for Bonus Malus Systems

In this paper we study a bonus malus system (bms) with deductibles. A bms is characterized by its premium levels and the transition rules among them. An insured is being moved among premium levels according to his/her claim record. Thus, an insured has to find an optimal strategy of submitting claims. Here optimal is in the sense of minimizing the total expected present value (epv) costs. Such strategies are found both for finite and infinite horizons. Furthermore, premium levels balancing the cost to the insured and the payoff of the insurer are given. The methods used to analyze the problem are from dynamic programming and Markov chains.     

Experts and quacks

What happens when “type” is endogenous in a reputational setting? Here, customers cannot tell “experts” from imitative “quacks,” but gain information through repeated interaction. Firm incentives to invest in expertise vary nonmonotonically in how tolerant customers are of bad outcomes; more tolerant customers are both more forgiving, making expertise less necessary, and longer tenured, increasing the value of retaining them. In equilibrium, the proportion of expert firms is bounded away from one; some quacks are necessary to keep incentives of experts in line. The fraction of experts is decreasing in customers' switching costs and the relative cost of expertise over quackery.     

Optimal dynamic hedging in incomplete futures markets

This article derives optimal hedging demands for futures contracts from an investor who cannot freely trade his portfolio of primitive assets in the context of either a CARA or a logarithmic utility function. Existing futures contracts are not numerous enough to complete the market. In addition, in the case of CARA, the nonnegativity constraint on wealth is binding, and the optimal hedging demands are not identical to those that would be derived if the constraint were ignored. Fictitiously completing the market, we can characterize the optimal hedging demands for futures contracts. Closed-form solutions exist in the logarithmic case but not in the CARA case, since then a put (insurance) written on his wealth is implicitly bought by the investor. Although solutions are formally similar to those that obtain under complete markets, incompleteness leads in fact to second-best optima.