Higher-Order Beliefs, Market-Based Incentives, and Information Quality

ABSTRACT

We investigate how interdependence among investors' beliefs affects the reliance on market prices as a performance measure and how this in turn affects the firm's preference for financial reporting quality. When investors want to align their values more with other investors' beliefs, optimal contracts become more reliant on the accounting report and less on the market price, emphasizing the stewardship role of accounting in a herding market. If the baseline accounting quality required by a reporting standard is high enough, the firm prefers to increase its accounting quality for the sake of contracting efficiency. However, if the baseline quality is low, the firm further lowers accounting quality for the same reason. The benchmark level that determines whether the firm prefers to increase accounting quality increases with the interdependence of investors' beliefs, implying that it is difficult to align the information and stewardship roles of accounting in a herding market.

Keywords:

• Higher-order beliefs
• Stock-based compensation
• Reporting quality
• Dual role of accounting

Acknowledgment

We thank the editor and two anonymous reviewers for many insightful comments and suggestions. We also thank Stefan Anchev, Christopher Bleibtreu, Robert Goex, Michael Kisser, Ulf Schiller, Li Yang, and seminar participants at the BI Norwegian Business School and University of Zurich for helpful comments and discussions.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 Well-known examples of market events induced by higher-order beliefs include the Dutch tulip mania in the 1630s and the Dotcom bubble in the 1990s. Investors buy overvalued assets as they believe other investors believe these assets are of high value.

2 Indeed, studies like those by Bushman and Indjejikian (1993), Kim and Suh (1993), and Feltham and Xie (1994) suggest market price as a potentially useful performance measure, because it aggregates otherwise noncontractible information, such as investors' equilibrium beliefs about management's actions.

3 In reality, although firms' accounting systems follow the requirements of accounting regulations, such as the International Financial Reporting Standards (IFRS) or US Generally Accepted Accounting Principles (US GAAP), firms also have some flexibility in influencing their own reporting.

4 Empirically, it is well established that managerial pay is based on both accounting and market measures of firm performance (e.g., Antle & Smith, 1986; Jensen & Murphy, 1990). For example, Lambert and Larcker (1987) and Sloan (1993) examine the determinants of the relative weights placed on accounting- and market-based performance measures in compensation contracts. Schöndube-Pirchegger and Schöndube (2010) show that market prices may be more suitable for contracting with the supervisory board than accounting reports.

5 More realistically, the firm value can be expressed as θ $=\mathrm{Ke}+s$, where K is a multiple of the manager's effort e. For simplicity, we assume K = 1 in our model.

6 As is common in higher-order belief models, s has an improper prior but a proper posterior. Specifically, the performance measures P and y in our setting are both featured with the posterior distributions of s and are normally distributed.

7 In reality, management may decide to bias its reports to the financial market and influence the firm's price into its desired direction. In our model, we refrain from including the manager's option to bias her report and view y as a noisy yet unbiased measure of the firm value.

8 For example, Balakrishnan et al. (2020) and Cremers et al. (2021) examine settings where higher-order beliefs among traders can be coordinated by analyst recommendations, resulting in the formation of asset bubbles. Their findings thus provide empirical evidence and the channel through which price bubbles are linked to higher-order beliefs.

9 One could argue that the investor's payoff should be stated as $A=\alpha (V-w)+(1-\alpha )(\theta -w)$, since θ is the gross firm value before the payment to the manager. However, since V is used as a performance measure in the contract, we follow the convention of the agency literature and use the gross outcome instead of the outcome net of w. See Hofmann et al. (2022) for a more detailed discussion and analyses on this issue.

10 As the effort e is the manager's decision variable and is a constant in equilibrium, the investors are essentially forming an expectation of the random variable s. Thus, equation (9) is equivalent to $v_i=e^{\ast }+\frac{(1-\alpha )\delta }{1-\mathrm{\alpha \delta }}(s+{ϵ}_i)+(1-\frac{(1-\alpha )\delta }{1-\mathrm{\alpha \delta }})(s+\eta ).$

11 Although $\mathrm{Cov}(P,y)$ is also part of the equilibrium results, it strictly decreases in $h_y$ and its effect on b is subsumed in the effect of $\mathrm{Var}\left(P\right)$.

12 Arguably, the main purpose of firms' accounting reports is to communicate with external stakeholders. In the following analyses, we focus on the partial equilibrium analyses on the effects of the precision of accounting reports on the managers' incentives, but acknowledge the limitation of this approach.