Showing papers in "Contemporary Accounting Research in 2006"

Audit Fees: A Meta-analysis of the Effect of Supply and Demand Attributes*

Abstract: We evaluate and summarize the large body of audit fee research and use meta-analysis to test the combined effect of the most commonly used independent variables. The perspective provided by the meta-analysis allows us to reconsider the anomalies, mixed results, and gaps in audit fee research. We find that, although many independent variables have consistent results, several show no clear pattern to the results and others only show significant results in certain periods or particular countries. These variables include a loss by the client and leverage, which have become significant in comparatively recent studies; internal auditing and governance, both of which have mixed results; auditor specialization, regarding which there is still some uncertainty; and the audit opinion, which was a significant variable before 1990 but not in more recent studies.

Expectations management and beatable targets: how do analysts react to explicit earnings guidance?

Abstract: This study investigates security analysts' reactions to public management guidance and assesses whether managers successfully guide analysts toward beatable earnings targets. We use a panel dataset between 1995 and 2001 to examine the fiscal-quarter-specific determinants of management guidance and the timing, extent, and outcomes of analysts' reactions to this guidance. We find that management guidance is more likely when analysts’ initial forecasts are optimistic, and, after controlling for the level of this optimism, when analysts’ forecast dispersion is low. Analysts quickly react to management guidance and they are more likely to issue final meetable or beatable earnings targets when management provides public guidance. Our evidence suggests that public management guidance plays an important role in leading analysts toward achievable earnings targets.

Ownership Structure, Business Group Affiliation, Listing Status, and Earnings Management: Evidence from Korea*

Abstract: Using a large sample of both publicly traded and privately held firms in South Korea (hereafter “Korea”), we investigate whether, and how, the deviation of controlling shareholders' control from ownership, business group affiliation, and listing status differentially affect the extent of earnings management. Our study yields three major findings. First, we find that as the control-ownership disparity becomes larger, controlling shareholders tend to engage more in opportunistic earnings management to hide their behavior and avoid adverse consequences such as disciplinary action. The result of our full-model regression reveals that an increase in the control-ownership wedge by 1 percent leads to an increase in the magnitude of (unsigned) discretionary accruals by 1.3 percent of lagged total assets, ceteris paribus. Second, we find that for our full-model regression, the magnitude of (unsigned) discretionary accruals is greater for group-affiliated firms than for nonaffiliated firms by 0.8 percent of lagged total assets. This result suggests that business group affiliation provides controlling shareholders with more incentives and opportunities for earnings management. Finally, we find that for our full-model regression, the magnitude of (unsigned) discretionary accruals is greater for publicly traded firms than for privately held firms by 1.2 percent of lagged total assets. This result supports the notion that stock markets create incentives for public firms to manage reported earnings to satisfy the expectations of various market participants that are often expressed in earnings numbers.

How Has Regulation FD Affected the Operations of Financial Analysts

Abstract: In this paper, we analyze how financial analysts generate information, make decisions about firm coverage, and try to maintain their forecasting accuracy after the passage of Regulation Fair Disclosure (“Reg FD”). Using the model developed by Barron, Kim, Lim, and Stevens 1998, we find that analysts are investing more effort in idiosyncratic information discovery. In order to do this, individual analysts appear to be reducing coverage for well-followed firms while increasing coverage of firms that were less followed prior to Reg FD. Analysts who had preferential links with firms that they covered, such as analysts from large brokerage houses, tend to have greater forecast accuracy in the pre-FD period. However, these analysts are unable to sustain their forecasting superiority in the post-FD period, which suggests that there has been a leveling of the information playing field among analysts. Overall, our results reflect a trend toward greater reliance on idiosyncratic information discovery on part of the financial analysts.

The Sarbanes‐Oxley Act of 2002 and Capital‐Market Behavior: Early Evidence*

Abstract: The Sarbanes-Oxley Act of 2002 (“the Act”) was enacted in response to numerous corporate and accounting scandals. It aims to reinforce corporate accountability and professional responsibility in order to restore investor confidence in corporate America. This study examines the capital-market reaction to the Act and finds a positive (negative) abnormal return at the time of several legislative events that increased (decreased) the likelihood of the passage of the Act. We interpret this finding as evidence supporting the notion that the Act is wealth-increasing in the sense that its induced benefits significantly outweigh its imposed compliance costs. We also find that the market reaction is more positive for firms that are more compliant with the provisions of the Act prior to its enactment.

Auditor Reputation, Auditor Independence, and the Stock-Market Impact of Andersen's Indictment on Its Client Firms*

Abstract: In this paper, we study a broad sample of Arthur Andersen clients and investigate whether the decline in Andersen's reputation, due to its criminal indictment on March 14, 2002, adversely affected the stock market's perception of its audit quality. Because these reputa-tional concerns are more of an issue if an auditor's independence is impaired, we investigate the relationship between the abnormal market returns for Andersen clients around the time of the indictment announcement and several fee-based measures of auditor independence. Our results suggest that when news about Andersen's indictment was released, the market reacted negatively to Andersen clients. More importantly, we find that the indictment period abnormal return is significantly more negative when the market perceived the auditor's independence to be threatened. We also examine the abnormal returns when firms announced the dismissal of Andersen as an auditor. Consistent with the audit quality explanation, we document that when firms quickly dismissed Andersen, the announcement returns are significantly higher when firms switched to a Big 4 auditor than when they either switched to non-Big 4 auditors or did not announce the identity of the replacement auditor. Our empirical results support the notion that auditor reputation and independence have a material impact on perceived audit quality and the credibility of audited financial statements, and that the market prices this.

Information Uncertainty and Analyst Forecast Behavior

Abstract: Prior literature observes that information uncertainty exacerbates investor underreaction behavior. In this paper, I investigate whether, as professional investment intermediaries, sell-side analysts suffer more behavioral biases in cases of greater information uncertainty. I show that greater information uncertainty predicts more positive (negative) forecast errors and subsequent forecast revisions following good (bad) news, which corroborates previous findings on the post-analyst-revision drift. The opposite effects of information uncertainty on forecast errors and subsequent forecast revisions following good versus bad news support the analyst underreaction hypothesis and are inconsistent with analyst forecast rationality or optimism suggested in prior literature.

Nonaudit Services and Earnings Conservatism: Is Auditor Independence Impaired?*

Abstract: We examine whether the provision of nonaudit services (NAS) by incumbent auditors is associated with a reduction in the extent to which earnings reflect bad news on a timely basis (that is, news-based conservatism). Reduced conservatism is expected to occur if relatively high levels of NAS result in reduced auditor independence and, ultimately, lower-quality auditing. Because client-specific demand for NAS is expected to vary, our proxy for the auditor-client economic bond is the extent to which NAS purchases (relative to audit fees) are greater or less than expected. Using several different methods for identifying news-based conservatism, we consistently find that higher than expected levels of NAS are not associated with reduced conservatism. This result is robust to allowing for endogenous NAS demand, as well as several explicit factors that may be associated with differences in conservatism. Similar conclusions arise from tests that use alternative measures of the economic bond between auditors and their clients, as well as in tests confined to either the Big 6 or non-Big 6 audit firms. Our results are consistent with factors such as market-based incentives, the threat of litigation, and alternative governance mechanisms offsetting any expected benefits to the audit firm from reducing its independence. We therefore conclude that recent legislative intervention aimed at restricting the supply of NAS is unlikely to result in increased independence in fact, although independence in appearance may be improved.

The Effect of Information Systems on Honesty in Managerial Reporting: A Behavioral Perspective*

Abstract: This study examines the behavioral impact of an information system, and how that impact varies with the information system's precision, in an internal reporting environment. We propose that a manager's reporting decisions are affected by his or her trade-off of the benefits of appearing honest against the benefits of misrepresentation. The information system affects the manager's trade-off by improving the owner's ability to make an inference regarding the manager's level of honesty. Thus, to the extent that the manager perceives benefits to appearing honest, the presence of an information system can increase managerial honesty. As the information system becomes more precise, however, the manager must forgo greater benefits of misrepresentation in order to achieve the same appearance of honesty. For managers under a precise system, this will shift the trade-off decision toward the benefits of misrepresentation and away from the benefits of appearing honest. Notably, in our experiment, the only benefit of appearing honest is an intrinsically motivated desire for social approval. We find that, although the existence of an information system increases managerial honesty, honesty is lower under a precise than under a coarse information system. We also compare profit earned by the owners in our experiment, which relies on a behavioral role of an information system, with the maximum profit theoretically possible given a contractual use of the information system. This comparison suggests that, unless the available information system is sufficiently precise, the owner will obtain greater profits by not contracting on its output, even if that output is fully contractible.

Are Auditors Compromised by Nonaudit Services? Assessing the Evidence*

Abstract: Ruddock, Taylor, and Taylor (2006) use an earnings conservatism framework to investigate the effects of nonaudit services (NAS) on earnings conservatism, and to test whether audit quality was impaired by NAS in Australia during the 1990s. They find no evidence of differential conservatism conditional on the level of NAS fees paid to auditors, and thus conclude that NAS have no adverse effect on audit quality. While this result may not extrapolate to the U.S. setting due to institutional difference between the two countries, the study does add to a growing body of empirical evidence that questions whether there is any logical rationale for restricting the scope of the services that auditors provide to their audit clients. In reviewing the NAS research literature over the past 40 years, one has to conclude that there is no “smoking gun” evidence linking the provision of nonaudit services with audit failures. However, the literature also finds that NAS can adversely affect the appearance of auditor independence, and this may be more than a “mere perception” problem, because there is also evidence that stock prices are significantly lower for companies that pay their auditors large fees for nonaudit services.

Do Investors Care about the Auditor's Economic Dependence on the Client?*

Abstract: In this study, we investigate whether investor perceptions of the financial reporting credibility of Big 5 audits are related to the auditor's economic dependence on the client as measured by nonaudit as well as total (audit and nonaudit) fees paid to the incumbent auditor. We use the client-specific ex ante cost of equity capital as a proxy for investor perceptions of financial reporting credibility and examine auditor fees both as a proportion of the revenues of the audit firm and as a proportion of the revenues of the audit firm's practice office through which the audit was conducted. Our findings suggest that both nonaudit and total fees are perceived negatively by investors' that is, the higher the fees paid to the auditor, the greater the implied threat to auditor independence, and the lower the financial reporting credibility of a Big 5 audit. Furthermore, our findings appear to be largely unrelated to corporate governance: investors do not perceive the auditor as compensating for weak governance. Separately, recent anecdotal evidence suggests that declining revenues from nonaudit services' as a result of recent regulatory restrictions” are being offset by substantial increases in audit fees. Other things being equal, rising audit fees imply higher profit margins for audit services, indicating that the audit function may no longer be a loss leader. Thus, to the extent that investors perceive total fees negatively, recent regulatory initiatives to limit nonaudit fees may not have adequately addressed the perceived, if not the actual, threat to auditor independence posed by fees.

Pricing of Initial Audit Engagements by Large and Small Audit Firms

Abstract: We investigate the extent to which auditors of U.S. companies reduce fees on initial audit engagements (“fee discounting”). We hypothesize that rivalries among sellers, in terms of client turnover and price competition, are more intense among small audit firms. The data support this hypothesis. New clients account for 34 percent of all clients for small audit firms, but only 9 percent of all clients for large audit firms. We theorize that differences in client turnover rates between large and small audit firms can be explained by the market structure of the audit industry, which consists of an oligopolistic segment dominated by a few large audit firms and an atomistic segment composed of many small audit firms. We further hypothesize and confirm that fee discounting is more extensive in the atomistic sector, and our results confirm this hypothesis. Our analysis of audit fee changes indicates that clients who switch auditors within the atomistic sector receive on average a discount of 24 percent over the prior auditor's fee. However, clients who switch auditors within the oligopolistic sector receive on average a discount of only 4 percent. Given that price competition is known to be less intense in oligopolistic markets than in atomistic markets, we believe that market structure theory can explain why fee discounting is lower when larger audit firms compete for clients.

Cherry Picking, Disclosure Quality, and Comprehensive Income Reporting Choices: The Case of Property‐Liability Insurers*

Abstract: Statement of Financial Accounting Standards No. 130: Reporting Comprehensive Income encourages enterprises to report comprehensive income on a performance statement rather than on a statement of equity. We investigate the reporting decisions of 82 publicly traded property-liability insurers that are fairly evenly split in their choice. Our results demonstrate that insurers with a tendency to manage earnings through realized securities' gains and losses (that is, cherry pickers), as well as insurers with a reputation for poor disclosure quality, are more likely to report comprehensive income in a statement of equity. Apparently, these insurers face the highest cost of transparency. We do not find a relation between the reporting decision and the volatility of comprehensive income relative to the volatility of net income. Our findings that insurers' comprehensive income reporting choices are a reflection of their proclivity toward cherry picking as well as their level of disclosure quality should be of interest to standard-setters because of the controversy over standard-setters' preference for mandating all firms to report comprehensive income in a performance statement.

The Persistence of the Accruals Anomaly

Abstract: The accruals anomaly — the negative relationship between accounting accruals and subsequent stock returns — has been well documented in the academic and practitioner literatures for almost a decade. To the extent that this anomaly represents market inefficiency, one would expect sophisticated investors to learn about it and arbitrage the anomaly away. We show that the accruals anomaly still persists and, even more strikingly, its magnitude has not declined over time. How can this be explained? We show that the accruals anomaly is recognized and, indeed, exploited by certain active institutional investors, but the magnitude of this accruals-related trading is rather small. By and large, institutions shy away from extreme accruals firms because their attributes, such as small size, low profitability, and high risk stand in stark contrast to those preferred by most institutions. Individual investors are also, by and large, unable to profit from trading on accruals information due to the high information and transaction costs associated with implementing a consistently profitable accruals strategy. Consequently, the accruals anomaly persists and will probably endure.

Learning by Doing and Audit Quality

Abstract: In this study, we present a nonstrategic, dynamic Bayesian model in which auditors' learning on the job and their choice of professional services jointly affect audit quality. While performing audits over time, auditors accumulate client-specific knowledge so that their posterior beliefs about clients are updated and become more precise (that is, precision is our surrogate for audit quality) — what we call the learning effect. In addition, auditors can enrich their knowledge accumulation by performing nonaudit services (NAS) that, in fact, may influence clients' managerial decisions — what we call the business advisory effect. This advisory effect permits auditors to anticipate and to learn about changes in clients' business models, which in turn improves their advisory capacity. These dual “learning” and “advisory” effects are interdependent and mutually reinforcing. The advisory effect of NAS may increase or reduce auditors' engagement risk. We show that large professional fees can induce auditors to provide NAS that increase engagement risk and diminish audit quality. However, when NAS reduce engagement risk and increase audit quality, auditors may provide NAS without charging clients. The feature that distinguishes our study — the interdependence between the learning and advisory effects — provides new insight into the trade-off between audit fees and audit quality. Consequently, our analysis helps explain why the scope of the audit has evolved over time and why the boundaries between audit and NAS are constantly shifting. A recent example of such a shift is that the Sarbanes-Oxley Act adds control attestation to audits for public companies traded in U.S. markets.

Employee Stock Option Fair-Value Estimates: Do Managerial Discretion and Incentives Explain Accuracy?*

Abstract: We examine the determinants of managers' use of discretion over employee stock option (ESO) valuation-model inputs that determine ESO fair values. We also explore the consequences of such discretion. Firms exercise considerable discretion over all model inputs, and this discretion results in material differences in ESO fair-value estimates. Contrary to conventional wisdom, we find that a large proportion of firms exercise value-increasing discretion. Importantly, we find that using discretion improves predictive accuracy for about half of our sample firms. Moreover, we find that both opportunistic and informational managerial incentives together explain the accuracy of firms' ESO fair-value estimates. Partitioning on the direction of discretion improves our understanding of managerial incentives. Our analysis confirms that financial statement readers can use mandated contextual disclosures to construct powerful ex ante predictions of ex post accuracy.

Are Securitizations in Substance Sales or Secured Borrowings? Capital-Market Evidence*

Abstract: Two standard-setting approaches have emerged globally to guide the choice of accounting for securitizations: the control and components approach (SFAS No. 125 and SFAS No. 140) and the risks and rewards transfer approach (IAS No. 39). A lack of consensus about derecognition accounting is a major impediment to achieving convergence in global standards that must be resolved. Thus, both SFAS No. 140 and IAS No. 39 will be reexamined, and evidence pertinent to the debate is timely and important. In this study, we present evidence consistent with the view of credit-rating analysts, who view many securitizations as, in substance, secured borrowings. Specifically, for a sample of originators applying sale accounting guidance in SFAS No. 125/140 during the period 1997-2003, we show that off-balance-sheet debt related to securitizations has, on average, the same risk-relevance for explaining market measures of risk (that is, CAPM beta) as on-balance-sheet debt. We also find that, in a returns and earnings association framework, the pricing multiple on securitization gains declines as the amount of off-balance-sheet debt increases, implying that investors take off-balance-sheet debt into account when assessing the valuation-relevance of such gains. For those who advocate the control and components approach to securitization accounting, our results suggest that, at least for frequent securitizers, the put option arising from implicit recourse is a "missing piece" that is not currently accounted for when calculating securitization gains. Our results challenge the extant measurement standards in SFAS No. 140.

Earnings Quality and the Equity Risk Premium: A Benchmark Model*

Abstract: This paper solves a model that links earnings quality to the equity risk premium in an infinite-horizon consumption capital asset pricing model (CAPM) economy. In the model, risk-averse traders hold diversified portfolios consisting of risk-free bonds and shares of many risky firms. When constructing their portfolios, traders rely on noisy reported earnings and dividend payments for information about the risky firms. The main new element of the model is an explicit representation of earnings quality that includes hidden accrual errors that reverse in subsequent periods. The model demonstrates that earnings quality magnifies fundamental risk. Absent fundamental risk, poor earnings quality cannot affect the equity risk premium. Moreover, only the systematic (undiversified) component of earnings-quality risk contributes to the equity risk premium. In contrast, all components of earnings-quality risk affect earnings capitalization factors. The model ties together consumption CAPM and accounting-based valuation research into one price formula linking earnings quality to the equity risk premium and earnings capitalization factors.

Accounting Information and CEO Compensation: The Role of Cash Flow from Operations in the Presence of Earnings*

Abstract: We examine the role of cash flow from operations (CFO) in chief executive officer (CEO) cash compensation. We predict that CFO is contract-relevant in the presence of earnings, and more so when (1) the quality of earnings relative to the quality of CFO as a measure of performance is low and (2) the need for CFO as a financing source is high. Our analysis is motivated principally by normative arguments and anecdotes from financial disclosures linking CFO to managerial effort and contracts, notwithstanding the traditional role of earnings in performance measurement. We find that the weight of CFO in the compensation model is positive and significant in the presence of earnings and stock returns. We also find that the relative quality of CFO compared with that of earnings has a positive (negative) impact on the weight of CFO (earnings). We further find that the relative weight of CFO is enhanced substantially when enterprise activities crucially depend on internally generated cash flow. These findings are unaltered when we include CEO age, firm size, and risk in the model and allow the coefficients to vary across industries.

Managing Stock Option Expense: The Manipulation of Option-Pricing Model Assumptions*

Abstract: This paper examines whether firms that voluntarily recognize stock option expense in their financial statements manage that expense downward more than firms that do not recognize the expense by adjusting option-pricing model assumptions. To examine this issue, I collect option-pricing model assumptions from fiscal year 2002 for both a sample of firms that voluntarily recognize stock option expense (“recognizing firms”) and a sample of control firms that do not (“disclosing firms”). The empirical results suggest that recognizing firms manage the recognized stock-based compensation expense reported in their financial statements downward more than do firms that only disclose the expense. Additional analyses reveal that recognizing firms assume a lower level of volatility than disclosing firms in the option-pricing model calculations; however, I find no evidence that recognizing firms manage the dividend yield and risk-free interest rate assumptions more than disclosing firms. The Financial Accounting Standards Board (FASB) recently issued Statement of Financial Accounting Standards No. 123(R), which requires the expensing of the fair value of stock options, so these results may be of interest to capital-market participants and the FASB as they assess the reliability of stock option expense as determined by option-pricing models.

An Economic Analysis of Audit and Nonaudit Services: The Trade-off between Competition Crossovers and Knowledge Spillovers*

Abstract: In this paper, I present a model in which both markets for audit services and nonaudit services (NAS) are oligopolistic. Accounting firms providing both audit services and NAS will employ oligopolistic competition in each of these markets. In addition to auditors' gaining “knowledge spillovers” from auditing to consulting or vice versa, oligopolistic competition in one market will influence the counterpart in the other market - what I call “competition crossovers”. Although scope economies due to knowledge spillovers (for example, cost savings) are always beneficial to auditors, such benefits can entice accounting firms to adopt strategies (for example, price reductions) to compete aggressively in the audit market so that some, or all, firms become worse off. A trade-off arises between these two economic forces in the two oligopolistic markets. Given the trade-off between competition crossovers and knowledge spillovers, accounting firms may not reduce their audit prices, even though supplying NAS enables firms to decrease auditing costs — a nontrivial impact of oligopolistic competition in two markets on audit pricing. The empirical implication of my results is that because of competition-crossover effects between the auditing and consulting service markets, finding empirical evidence for knowledge-spillover benefits is likely to be difficult. Control variables for “audit-market concentration” concerned with competition-crossover effects and “auditor expertise” concerned with knowledge-spillover benefits should be included in audit-fee regressions to increase the power of empirical tests. With regard to policy implications, my analyses help explain the impact of the Sarbanes-Oxley Act on “market segmentation” and, hence, the profitability of accounting firms.

Horizon‐Dependent Underreaction in Financial Analysts' Earnings Forecasts*

Abstract: This paper provides empirical evidence that underreaction in financial analysts' earnings forecasts increases with the forecast horizon, and offers a rational economic explanation for this result. The empirical portion of the paper evaluates analysts' responses to earnings-surprise and other earnings-related information. Our empirical evidence suggests that analysts' earnings forecasts underreact to both types of information, and the underreaction increases with the forecast horizon. The paper also develops a theoretical model that explains this horizon-dependent analyst underreaction as a rational response to an asymmetric loss function. The model assumes that, for a given level of inaccuracy, analysts' reputations suffer more (less) when subsequent information causes a revision in investor expectations in the opposite (same) direction as the analyst's prior earnings-forecast revision. Given this asymmetric loss function, underreaction increases with the risk of subsequent disconfirming information and with the disproportionate cost associated with revision reversal. Assuming that market frictions prevent prices from immediately unraveling these analyst underreac-tion tactics, investors buying (selling) stock on the basis of analysts' positive (negative) earnings-forecast revisions also benefit from analyst underreaction. Therefore, the asymmetric cost of forecast inaccuracy could arise from rational investor incentives consistent with a preference for analyst underreaction. Our incentives-based explanation for underreaction provides an alternative to psychology-based explanations and suggests avenues for further research.

Conservative accounting and linear information valuation models

Abstract: Prior research using the residual income valuation model and linear information models has generally found that estimates of firm value are negatively biased. We argue that this could result from the way in which accounting conservatism effects are reflected in such models. We build on the conservative accounting model of Feltham and Ohlson (1995) and the Dechow, Hutton and Sloan (1999) (DHS) methodology to propose a valuation model that includes a conservatism-correction term, based on the properties of past realizations of residual income and other information. Other information is measured using analyst-forecast-based predictions of residual income. We use data comparable to the DHS sample to compare the bias and inaccuracy of value estimates from our model and from models similar to those used by DHS and Myers (1999). Valuation biases are substantially less negative for our model, but valuation inaccuracy is not markedly reduced.

Auditor Liability and Business Investment

Abstract: We model a firm's investment decision, an auditor's effort-rendering behavior, audit fees, and prices of the firms under two auditor liability rules: strict liability and negligence liability. We show that an auditor's effort level is socially optimal under strict liability, while it is not generally so under negligence liability. Furthermore, both the firm owner's expected benefit and the audit fee are higher under strict liability than under negligence liability. We define the legal error under negligence liability as the difference between the assessed audit effort (that is, the estimate of audit effort made by the court) and the actual audit effort and prove that the greater the variance of the legal error, the more incentive an auditor has to exert effort under negligence liability compared with strict liability. Finally, the number of investments being undertaken could be higher under strict liability because more firm owners are willing to hire auditors to go public.

An Experimental Test of the Interaction of the Insurance and Information-Signaling Hypotheses in Auditing*

Abstract: Three incentives for hiring auditing services have been proposed in the literature: (1) to signal outsiders about the company's prospects, (2) to provide a potential source of loss recovery for investors (insurance), and (3) to reduce agency costs. The objective of this study is to examine the potential for the first two (signaling and insurance) to interact while controlling for agency costs. We conduct an experiment in which highly experienced financial analysts provide stock price estimates for a company that is under financial stress. We manipulate, between participants, the signal provided by the audit opinion (going-concern modification, yes/no) and the ability of investors to recover losses from auditors. The key finding is that the effect of the going-concern opinion on investor value judgements is moderated by the extent to which the auditor provides an insurance function. Specifically, the negative effect of a going-concern opinion on the analysts' stock price estimates is reduced by the extent that the environment treats the auditor as an insurer.

Accounting Discretion and Managerial Conservatism: An intertemporal analysis *

Abstract: Accounting discretion and the principle of conservatism are two salient features embedded in financial reporting systems. Arguably, the practice of conservative accounting choices can never be well understood without incorporating their effect on future periods (the intertemporal effect). This paper provides one explanation for managerial conservatism in a two-period agency model with hidden information (a binary project type) and hidden actions (the agent's efforts). A piece-wise linear incentive scheme with accounting earnings as the performance measure is employed. The agent's discretion is the choice of a depreciation method. Discretion is valuable if and only if the agent's marginal productivity of a “bad” project is greater than that of a “good” project, but not to an extreme degree. A conservative depreciation method decreases current compensation in exchange for a “bet” on future compensation and, hence, serves as a commitment device for the agent to signal that the prospect is indeed good. The accounting mechanism replicates the performance of the optimal direct mechanism.

Who Benefits from Inconsistent Multinational Tax Transfer-Pricing Rules?*

Abstract: This paper uses a strategic tax compliance model to examine taxpayer reporting and tax authority audit strategies in an international setting with two tax authorities. The setting features both information asymmetry between the taxpayer and the tax authorities and inconsistent tax transfer-pricing rules. The latter creates the possibility of each country trying to tax the same income. We study the effect of the probability of transfer-price rule inconsistency on the strategies and payoffs of the taxpayer and the tax authorities. We find that an increase in the probability of transfer-price rule inconsistency induces more aggressive auditing by governments. It therefore deters taxpayers from shifting income to the country with the lower tax rate in situations in which the transfer-pricing rules are consistent, and can either increase or decrease the income reported to the low-tax-rate country in cases in which the transfer-pricing rules are inconsistent. We find that an increase in transfer-price rule inconsistency could either increase or decrease the taxpayer's expected tax liability and could either increase or decrease the deadweight loss from auditing. Our results call into question the conventional wisdom that the prospect of double taxation due to transfer-price rule inconsistency increases a firm's expected tax liability and governments' expected audit costs.

Unintended Effects of Preannouncements on Investor Reactions to Earnings News

Abstract: This study uses an experiment to examine three alternative theoretical explanations for the unintended effects of preannouncements on investor reactions to earnings news. The theoretical explanations are cue consistency, recency effects, and diminishing marginal reactions. The experiment varies the amount of a management preannouncement at five different levels while holding constant consensus analyst expectations prior to the preannouncement and the subsequent earnings announcement. Participants provide preliminary forecasts of current- and next-period earnings per share (EPS) prior to the preannouncement, after the preannouncement, and after the earnings announcement. The pattern of participants' final next-year EPS forecasts and the results of follow-up analyses appear most consistent with the predictions of diminishing marginal reactions and, to a somewhat lesser extent, cue consistency, suggesting that both mechanisms play a role in determining the effects of preannouncements. There is little evidence supporting recency effects. Finally, supplemental evidence indicates that participants are unaware that preannouncements influence their reactions to earnings news, suggesting that the effects are unintended. This study has implications for managers who make preannouncement disclosure decisions and for academics who wish to understand and interpret prior research on earnings preannouncements.

Managing Perceptions of Technical Competence: How Well Do Auditors Know How Others View Them?*

Abstract: We investigate factors that influence an auditor's accuracy in knowing how subordinates, peers, and superiors view his or her own technical competence (metaperception). Extant literature on reputation management in auditing contexts depicts preparers of audit workpapers as strategic agents (subordinates) who stylize workpapers and engage in behaviors that enhance their reputations with reviewers (superiors). These superiors, in turn, are represented as strategically engaging in coping behaviors in response to such stylization attempts. One of the necessary conditions for auditors to enhance their reputations on a sustainable basis is accurate metaperception. We report the results of an experiment that investigates determinants of auditors' metaperception accuracy. Our participants comprise teams of audit partners, managers, and seniors who work together in the field. Each auditor performs two tasks of varying complexity and then predicts whether other team members can accurately perform the task and how other team members assess his or her performance on the tasks. Results show that accuracy in knowing what others think of one's technical proficiency (metaperception) is generally high, particularly when the predictor auditors are partners and managers; however, metaperception accuracy is asymmetric and varies depending on the predictor auditor, the target auditor being predicted, and task complexity. Implications are discussed.