The Investment Opportunity Set and Industry Specialization by Auditors
By
Steven F. Cahan,
Jayne M. Godfrey ,
Jane Hamilton , and Debra C. Jeter
ABSTRACT
While auditor industry specialization has attracted widespread interest in the academic literature, one of the most fundamental questions remains unanswered: Why do some industries lend themselves to more intensive auditor specialization than others? In this study, we posit that IOS plays an important role in determining whether an industry is an attractive target for auditor specialization. We argue that when industry-specific IOS is high, auditors must make costly industry-specific investments that allow them to offer a differentiated product and create entry barriers for other audit firms. However, when a large component of IOS is unique to specific firms within an industry (i.e., IOS is highly variable within the industry), this creates unique knowledge requirements for the firm’s auditor, and it is more difficult to transfer knowledge and spread costs across clients in that industry. Using two different measures of IOS and three alternative industry classification schemes, we present evidence that auditor specialization is increasing in industry IOS levels and decreasing in within-industry IOS variability.
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3/18/2008
LONG-RUN SEASONED EQUITY OFFERING RETURNS
LONG-RUN SEASONED EQUITY OFFERING RETURNS:
DATA SNOOPING, MODEL MISSPECIFICATION, OR MISPRICING?
A COSTLY ARBITRAGE APPROACH (55 pgs)
by
Jeffrey Pontiff
Michael J. Schill
ABSTRACT
This paper uses a new approach to assess return behavior after seasoned equity offerings. Our approach recognizes that sophisticated investors are motivated to correct mispricing, although the magnitude of their activity is influenced by arbitrage costs. This approach avoids inference problems due to model misspecification or data snooping. The evidence supports the contention
that firms that conduct seasoned equity offerings are overpriced. Our findings imply that, since mispricing associated with seasoned equity offerings is persistent in the long-run, holding costs play an important role although transaction costs do not. In fact, holding costs dominate the size effect documented by previous research.
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DATA SNOOPING, MODEL MISSPECIFICATION, OR MISPRICING?
A COSTLY ARBITRAGE APPROACH (55 pgs)
by
Jeffrey Pontiff
Michael J. Schill
ABSTRACT
This paper uses a new approach to assess return behavior after seasoned equity offerings. Our approach recognizes that sophisticated investors are motivated to correct mispricing, although the magnitude of their activity is influenced by arbitrage costs. This approach avoids inference problems due to model misspecification or data snooping. The evidence supports the contention
that firms that conduct seasoned equity offerings are overpriced. Our findings imply that, since mispricing associated with seasoned equity offerings is persistent in the long-run, holding costs play an important role although transaction costs do not. In fact, holding costs dominate the size effect documented by previous research.
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The Theory of Financial Intermediation
The Theory of Financial Intermediation
by
Franklin Allen
Anthony M. Santomero
Keywords: intermediation, risk management delegated monitoring, banks, participation costs
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by
Franklin Allen
Anthony M. Santomero
Abstract:
Traditional theories of intermediation are based on transaction costs and asymmetric information. They are designed to account for institutions which take deposits or issue insurance policies and channel funds to firms. However, in recent decades there have been significant changes. Although transaction costs and asymmetric information have declined, intermediation has increased. New markets for financial futures and options are mainly markets for intermediaries rather than individuals or firms. These changes are difficult to reconcile with the traditional theories. We discuss the role of intermediation in this new context stressing risk trading and participation costs.
Traditional theories of intermediation are based on transaction costs and asymmetric information. They are designed to account for institutions which take deposits or issue insurance policies and channel funds to firms. However, in recent decades there have been significant changes. Although transaction costs and asymmetric information have declined, intermediation has increased. New markets for financial futures and options are mainly markets for intermediaries rather than individuals or firms. These changes are difficult to reconcile with the traditional theories. We discuss the role of intermediation in this new context stressing risk trading and participation costs.
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3/09/2008
Are Internal Capital Markets Good for Innovation?
Are Internal Capital Markets Good for Innovation?
By
Peter G. Klein
Contracting and Organizations Research Institute
University of Missouri
Abstract:
Which type of firm is more innovative: the decentralized, diversified corporation or the smaller, more narrowly focused “entrepreneurial” firm? According to one argument, diversified corporations can do more R&D because their operating units have access to an internal capital market. Other writers argue that decentralized, diversified firms over-rely on financial accounting criteria to evaluate the performance of their operating units, discouraging divisional managers from investing in projects like R&D with long-term, uncertain payoffs. This paper uses a comprehensive sample of diversified and nondiversified firms from 1980 to 1999 to study the relationship between diversification and innovation. I find a robust negative correlation between diversification and R&D intensity, even when controlling for firm scale, cash flow, and investment opportunities. Industry-adjusted R&D—the difference between the R&D intensity of a diversified firm and the R&D intensity it would most likely have if its divisions were standalone firms—is negative, consistent with the hypothesis that diversification reduces innovation by discouraging R&D investment. However, other evidence suggests that internal-capital-market inefficiencies, rather than managerial myopia, are driving the negative relationship between diversification and innovation.
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By
Peter G. Klein
Contracting and Organizations Research Institute
University of Missouri
Abstract:
Which type of firm is more innovative: the decentralized, diversified corporation or the smaller, more narrowly focused “entrepreneurial” firm? According to one argument, diversified corporations can do more R&D because their operating units have access to an internal capital market. Other writers argue that decentralized, diversified firms over-rely on financial accounting criteria to evaluate the performance of their operating units, discouraging divisional managers from investing in projects like R&D with long-term, uncertain payoffs. This paper uses a comprehensive sample of diversified and nondiversified firms from 1980 to 1999 to study the relationship between diversification and innovation. I find a robust negative correlation between diversification and R&D intensity, even when controlling for firm scale, cash flow, and investment opportunities. Industry-adjusted R&D—the difference between the R&D intensity of a diversified firm and the R&D intensity it would most likely have if its divisions were standalone firms—is negative, consistent with the hypothesis that diversification reduces innovation by discouraging R&D investment. However, other evidence suggests that internal-capital-market inefficiencies, rather than managerial myopia, are driving the negative relationship between diversification and innovation.
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3/07/2008
AN INVESTIGATION OF EARNINGS MANAGEMENT
AN INVESTIGATION OF EARNINGS MANAGEMENT THROUGH INVESTMENTS IN ASSOCIATED COMPANIES: AN AUSTRALIAN PERSPECTIVE
Cecilia Lambert*
Christopher Lambert**
ABSTRACT
Until recently, Australian companies have been precluded from adopting equity accounting for investments in associated companies in the consolidated accounts. As reported profits were based on the cost method (albeit with note disclosures utilising equity accounting procedures), this paper investigates the incentives of Australian firms to manage earnings in a reporting environment which facilitated opportunism. It is argued that the higher the ex ante probability of managing accounting earnings from investments in associates, parties will contract to remove those incentives by restricting the accepted set of accounting procedures to equity accounting. Opportunism is more likely to be observed for firms for which it is inefficient to ex ante specify the method of accounting for associates. The ability to act opportunistically is defined as the degree of influence which an investor exercises over the financial and/or operating policies of its investees. The results are confirmatory. For firms which have a lower ex ante probability of managing earnings, use of the cost method significantly improves consolidated return on investment compared with returns calculated using the equity method. Firms which are more likely to choose the equity method for efficiency reasons have an insignificant difference between cost and equity returns.
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Cecilia Lambert*
Christopher Lambert**
ABSTRACT
Until recently, Australian companies have been precluded from adopting equity accounting for investments in associated companies in the consolidated accounts. As reported profits were based on the cost method (albeit with note disclosures utilising equity accounting procedures), this paper investigates the incentives of Australian firms to manage earnings in a reporting environment which facilitated opportunism. It is argued that the higher the ex ante probability of managing accounting earnings from investments in associates, parties will contract to remove those incentives by restricting the accepted set of accounting procedures to equity accounting. Opportunism is more likely to be observed for firms for which it is inefficient to ex ante specify the method of accounting for associates. The ability to act opportunistically is defined as the degree of influence which an investor exercises over the financial and/or operating policies of its investees. The results are confirmatory. For firms which have a lower ex ante probability of managing earnings, use of the cost method significantly improves consolidated return on investment compared with returns calculated using the equity method. Firms which are more likely to choose the equity method for efficiency reasons have an insignificant difference between cost and equity returns.
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