Instrumental variable (IV) methods are increasingly being used in earnings management, corporate governance, executive compensation, and disclosure research where there is reason to believe that regressor variables are endogenous. While IV estimation is the standard textbook solution to mitigating the inconsistency in parameter estimates caused by endogeneity, the appropriateness of IV methods in typical accounting research settings is not obvious. Drawing on recent advances in statistics and econometrics, we provide conditions under which IV methods are likely to be preferred to traditional ordinary least squares (OLS). These results raise considerable doubt about the appropriateness of typical IV applications in accounting research. We illustrate these concerns by examining the association between corporate disclosure and the cost of capital. Our results indicate that the commonly used instruments are unlikely to provide estimates that are preferable to OLS.

This paper examines the effect of transaction costs on the post-earnings-announcement drift (PEAD). Using standard market microstructure features we show that transaction costs constrain the informed trades that are necessary to incorporate earnings information into price. This leads to weaker return responses at the time of the earnings announcement and higher subsequent returns drift for firms with high transaction costs. Consistent with this prediction, we find that earnings response coefficients are lower for firms with higher transaction costs. Using portfolio analyses, we find that the profits of implementing the PEAD trading strategy are significantly reduced by transaction costs. In addition, we show, using a combination of portfolio and regression analyses, that firms with higher transaction costs are the ones that provide the higher abnormal returns for the PEAD strategy. Our results indicate that transaction costs can provide an explanation not only for the persistence but also for the existence of PEAD.

This discussion reinforces and expands on some of the fundamental issues about endogeneity raised by Chenhall and Moers (European Accounting Review, 2007, pp. 173-195). We focus on the econometric problems researchers encounter when investigating the performance effects of some endogenous firm choice. Our points are illustrated using the classic research question about the relation between managerial equity ownership and firm value. We consider cases where ownership is treated as an exogenous, endogenous and 'partially' endogenous variable. We argue treating ownership as an exogenous variable is seriously flawed. Unfortunately, when ownership is at least partially endogenous, it is necessary for empirical researchers to identify exogenous variables that are the determinants of the ownership choice. This calls for better theory to guide the empirical work.

We investigate Gompers, Ishii, and Metrick's (2003) finding that firms with weak shareholder rights exhibit significant stock market underperformance. If the relation between poor governance and poor returns is causal, we expect that the market is negatively surprised by the poor operating performance of weak governance firms. We find that firms with weak shareholder rights exhibit significant operating underperformance. However, analysts' forecast errors and earnings announcement returns show no evidence that this underperformance surprises the market. Our results are robust to controls for takeover activity. Overall, our results do not support the hypothesis that weak governance causes poor stock returns.

We investigate the economic determinants of CEO stock option grant vesting periods and provide evidence that firms use vesting periods strategically. We examine vesting schedules for a large sample of firms using information extracted from Form 4 insider trading filings. Contrary to a commonly held belief that firms use boilerplate vesting schedules, we document significant variation in the vesting periods of option grants. We test for several economic motivations for vesting terms, including the desire to extend the executive’s investment horizon, to allow for rebalancing of risk-taking incentives, to promote executive retention, and to provide liquidity when equity is used mainly for compensation. We find that the restrictiveness of the vesting schedule depends on the primary motivation for granting options. When the objective is to retain the executive and provide long horizon incentives, firms use longer vesting periods. However, when the option grant is primarily to compensate the CEO, firms use shorter vesting periods. We find some evidence that poor governance is associated with shorter vesting and that the composition of institutional ownership influences vesting. We also find firms extend their vesting periods postpone the accounting expense and to smooth out the income statement effect of any given year’s grant. We find this both for firms voluntarily expensing their stock options and in later periods when expensing is mandated under SFAS 123(R). Overall, this study provides evidence that vesting terms are an important component of executive compensation.

Severance agreements provide an interesting exception to the pay-for-performance paradigm. Not only do executives get paid after being fired, but frequently the payments are already contracted upon at the time the CEO is appointed. The main objective of this paper is to investigate the reasons why firms would commit to pay large amounts to CEOs that are fired. We distinguish between the need to provide insurance against uncertainty about the (continued) fit between the CEO and the firm and the need to provide incentives to the CEO. The theoretical literature on severance has proposed that severance provides incentives to take on more risky projects, to make more relationship specific investments and to increase the timely disclosure of bad news. We use a random sample of S&P 1500 firms, and investigate which hypothesis can best explain which firms adopt severance agreements, and for which amounts. Second, we investigate whether the future actions by the CEO and the firm are consistent with the effects predicted by the theories. Overall, our results are most consistent with severance being used as insurance against poor fit and firm risk.