Reputation Concerns and Herd Behavior of Audit Committees - A Corporate Governance Problem

This paper offers an explanation for audit committee failures within a corporate governance context. We consider a setting in which the management of a firm sets up financial statements that are possibly biased. These statements are reviewed/audited by an external auditor and by an audit committee. Both agents report the result of their audit, the auditor acting first. The auditor and the audit committee use an imperfect auditing technology. As a result of their work they privately observe a signal regarding the quality of the financial statements. The probability for a correct signal in the sense that an unbiased report is labeled correct and a biased one incorrect, depends on the type of the agent. Good as well as bad agents exist in the economy. Importantly, two good agents observe identical informative signals while the signal observed by a bad agent is uninformative and uncorrelated to those of other good or bad agents.The audit committee as well as the auditor are anxious to build up reputation regarding their ability in the labor market. Given this predominate goal they report on the signal in order to maximize the market´s assessment of their ability. At the end of the game the true character of the financial statements is revealed to the public with some positive probability. The market uses this information along with the agents´ reports to update beliefs about the agents´ types. We show that a herding equilibrium exists in which the auditor reports based on his signal but the audit committee "herds" and follows the auditor´s judgement no matter what its own insights suggest. This results holds even if the audit committee members are held liable for detected failure. However, performance based bonus payments induce truthful reporting at least in some cases.corporate governance, audit committee, game theory, herding, incentive contracts

The Value of Delegation in a Dynamic Agency

In this paper we analyze the value of delegation in a two-period agency. A central management hires an agent to perform a personal effort in each period. Due to time constraints or lack of ability this effort can not be performed by central management. Besides personal effort firm value is influenced by the decision to launch a project which has to be made at the beginning of period two. The project decision can either be delegated to the agent (decentralization) or it can be made by central management (centralization). Under decentralization the agent observes the project’s contribution before its decision. While this captures the benefit of delegation its cost is that the project decision is unobservable and must be motivated together with personal effort via the same incentive contract. In the centralized regime, in contrast, no incentives for the project decision are necessary, however, the project’s actual contribution will not be observed such that the project decision has to be made based on expectations. We analyze optimal performance measurement for both regimes in a linear contracting setting and analyze the variables that affect the value of delegation. We do this for two different contracting regimes: long-term commitment and long-term renegotiation-proof contracts. Trade-offs under both contracting environments differ substantially. In particular, under renegotiation-proof contracts, decentralization might become optimal even if its direct benefit in terms of acquiring specific knowledge about the project vanishes. The reason is that with delegation of the project decision central management implicitly commits to a higher second period incentive rate as personal effort and the project decision must be controlled via the same incentive contract. This is beneficial if renegotiation-proofness requires central management to set too low second-period incentives compared to long-term commitment. A necessary condition for that is, that intertemporal correlation is negative. Contrary to the classical view this result implies that the incentive problem under centralization may become more severe than under decentralization.

Corporate Governance, Reputation Concerns, and Herd Behavior

This paper offers an explanation for audit committee failures within a corporate governance context. We consider a setting in which the management of a firm sets up financial statements that are possibly biased. These statements are reviewed/audited by an external auditor and by an audit committee. Both agents report the result of their audit, the auditor acting first. The auditor and the audit committee use an imperfect auditing technology. As a result of their work they privately observe a signal regarding the quality of the financial statements. The probability for a correct signal in the sense that an unbiased report is labelled correct and a biased one incorrect, depends on the type of the agent. Good as well as bad agents exist in the economy. Importantly, two good agents observe identical informative signals while the signal observed by a bad agent is uninformative and uncorrelated to those of other good or bad agents. The audit committee as well as the auditor are anxious to build up reputation regarding their ability in the labor market. Given this predominate goal they report on the signal in order to maximize the market’s assessment of their ability. At the end of the game the true character of the financial statements is publicly learned and the market uses this information along with the agents’ reports to update beliefs about the agents’ type. We show that herding equilibria exist in which the auditor reports based on his signal but the audit committee .herds. and follows the auditor’s judgement no matter what its own insights suggest.corporate governance, audit committee, game theory, herding

Early versus late accounting information in a limited commitment setting

We consider a two period principal-agent problem in a LEN setting. Stock prices as well as accounting measures are available for incentive contracting. The principal needs to implement one out of two accounting systems. While the early accounting information system reports an accounting signal in the period it is produced, the late accounting system reports this information with one period delay. As accounting information is considered contractible if and only if it is reported within the two period horizon of the game, the late system ends up providing less contractible information than the early one. Accounting information is supposed to be effort informative and value relevant. Stock prices reflect all value relevant information. This includes accounting information along with further information that is value relevant but not effort informative. We derive optimal compensation contracts in a full commitment setting and in a limited commitment setting for both, the early and the late accounting information system. With full commitment the early system dominates the late one. If the early system is implemented stock prices are not used for contracting at all. In contrast, if the late system is present, stock prices are required to incentivice second period effort at all. However, contracting on them results in an inferior risk-incentive trade-off as compared to contracting on early accounting information only. With limited commitment implementing the late accounting information system may bene.t the principal. If accounting signals are positively correlated, limited commitment causes excessive second period incentive rates. Using the late system in combination with stock prices serves as a commitment device. Noise immanent in the stock prices reduces optimal incentive rates and thus counteracts the over-incentives. Second period benefits may more than outweigh the cost related to using stock prices in the first period

The Value of Delegation in a Dynamic Agency

In this paper we analyze the value of delegation in a two-period agency. A central management hires an agent to perform a personal effort in each period. Due to time constraints or lack of ability this effort can not be performed by central management. Besides personal effort firm value is influenced by the decision to launch a project which has to be made at the beginning of period two. The project decision can either be delegated to the agent (decentralization) or it can be made by central management (centralization). Under decentralization the agent observes the project\u27s contribution before its decision. While this captures the benefit of delegation its cost is that the project decision is unobservable and must be motivated together with personal effort via the same incentive contract. In the centralized regime, in contrast, no incentives for the project decision are necessary, however, the project\u27s actual contribution will not be observed such that the project decision has to be made based on expectations. We analyze optimal performance measurement for both regimes in a linear contracting setting and analyze the variables that affect the value of delegation. We do this for two different contracting regimes: long-term commitment and long-term renegotiation-proof contracts. Trade-offs under both contracting environments differ substantially. In particular, under renegotiation-proof contracts, decentralization might become optimal even if its direct benefit in terms of acquiring specific knowledge about the project vanishes. The reason is that with delegation of the project decision central management implicitly commits to a higher second period incentive rate as personal effort and the project decision must be controlled via the same incentive contract. This is beneficial if renegotiation-proofness requires central management to set too low second-period incentives compared to long-term commitment. A necessary condition for that is, that intertemporal correlation is negative. Contrary to the classical view this result implies that the incentive problem under centralization may become more severe than under decentralization

Reputation Concerns and Herd Behavior of Audit Committees: A Corporate Governance Problem

This paper offers an explanation for audit committee failures within a corporate governance context. We consider a setting in which the management of a firm sets up financial statements that are possibly biased. These statements are reviewed/audited by an external auditor and by an audit committee. Both agents report the result of their audit, the auditor acting first. The auditor and the audit committee use an imperfect auditing technology. As a result of their work they privately observe a signal regarding the quality of the financial statements. The probability for a correct signal in the sense that an unbiased report is labeled correct and a biased one incorrect, depends on the type of the agent. Good as well as bad agents exist in the economy. Importantly, two good agents observe identical informative signals while the signal observed by a bad agent is uninformative and uncorrelated to those of other good or bad agents.The audit committee as well as the auditor are anxious to build up reputation regarding their ability in the labor market. Given this predominate goal they report on the signal in order to maximize the market´s assessment of their ability. At the end of the game the true character of the financial statements is revealed to the public with some positive probability. The market uses this information along with the agents´ reports to update beliefs about the agents´ types. We show that a herding equilibrium exists in which the auditor reports based on his signal but the audit committee "herds" and follows the auditor´s judgement no matter what its own insights suggest. This results holds even if the audit committee members are held liable for detected failure. However, performance based bonus payments induce truthful reporting at least in some cases

Trust and Adaptive Learning in Implicit Contracts

We study e¤ects of trust in implicit contracts. Trust changes whenever the principal honors or dishonors an implicit contract. Usually a higher discount rate lowers the value of trade in an agency. We show that a su¢ ciently high level of (ex ante) trust can o¤set this ef- fect. Strategies of principals representing unique equilibria are endogenously derived given di¤erent levels of agents’bounded rationality. These strategies mirror a subset of the class of trigger strategies which is exogenously entered into previous implicit contracting models. Therefore our results o¤er some justi…cation for using that conventional approach. Implications for performance evaluation are discussed.trust, implicit contracts, bounded rationality, adaptive learning, trigger strate- gies, game theory

Full versus Partial Delegation in Multi-Task Agency

We consider a moral hazard type agency problem. Two tasks need to be performed within the agency. The principal can either delegate both tasks to the agent or perform one of the tasks himself. In the latter case the principal can choose which task to delegate but doing both personally is not feasible. As firm value is not contractible by assumption the incentive contract offered to the agent needs to be based on a possibly non-congruent performance measure. Allowing for both of the players to be risk averse, agency costs can arise from a trade-off in allocating incentives and risk as well as from a congruity problem. While full delegation results in a standard two task agency problem, partial delegation creates a double moral hazard problem as neither the principal can observe the agent’s effort nor vice versa. We find that full delegation is more favorable the more risk is optimally allocated to the agent. Accordingly partial delegation is beneficial if the principal has a relatively low degree of risk aversion. Moreover, full delegation allows the principal to scale incentives provided to the agent but not to fine tune the intensity of incentives for each effort separately. With partial delegation fine tuning is possible but increasing incentives for one effort implies reducing them for the other. If scaling is more effective in minimizing agency costs than fine tuning incentives, the principal tends to prefer full delegation to partial delegation and vice versa

Relevance versus reliability of accounting information with unlimited and limited commitment

We consider a two-period LEN-type agency problem. The principal needs to implement one out of two accounting systems. One emphasizes relevance, the other reliability. Both systems produce identical inter-temporally correlated signals. The relevant system reports an accounting signal in the period in which it is produced. The reliable system reports a more precise signal, but with a one period delay. Accounting information is contractible only if it is reported within the two-period horizon of the game. Accordingly, accounting information produced in the second period becomes uncontractible with the reliable system in place. Non-accounting information needs to be used for contracting to provide any second period incentives at all. We derive optimal compensation contracts in a full and in a limited commitment setting. With full commitment, the reliable system trades-off more precise first and less precise second-period contractible information, as compared to the relevant system. If the reduction of noise in the accounting signals is strong and the distortion in the non-accounting measure is weak, the reliable system is preferred. With limited commitment we identify a similar trade-off if intertemporal correlation of the signals is negative. If it is positive, this trade-off might reverse: The reliable system is possibly preferred if noise reduction is small and the non-accounting measure is heavily distorted. Noisiness in performance measures then serves as a commitment device. It reduces otherwise overly high powered incentives and thus benefits the principal

Corporate Governance, Human Capital Investment, and Job Termination Clauses: A Lesson from the Literature on Hold-Up

This paper examines a principal-agent problem between a manager (principal) and an employee (agent). At the contracting date uncertainty with regard to the profitability of the relationship is present. Once the contract is signed, the employee performs a specific investment that reduces his disutility from working hard. After that, but before the employee performs his effort, the uncertainty is resolved. The manager and the employee are free to renegotiate the contract at this point. Moreover, we distinguish three settings with respect to the principal\u27s and the agent\u27s options to terminate the relationship irrespective of possible renegotiation. If both parties are free to quit we find that an underinvestment problem with regard to the employee\u27s personal investment is present. If none of the parties are allowed to breach the contract, an overinvestment problem arises. Finally, allowing the employee to quit but not the manager allows achieving first best investment