Showing papers in "Contemporary Accounting Research in 2007"

Auditors' Governance Functions and Legal Environments: An International Investigation*

Abstract: This paper uses a set of firm-level data across 39 countries to study whether national legal environments increase or decrease auditors' governance functions in serving the bonding and signaling role. On the one hand, Big Five auditors may play a stronger governance role in weaker legal environments because they are good substitutes for legal protection of outside investors and risky firms find Big Five auditors more affordable due to lower litigation costs. On the other hand, a country's poor legal environment may significantly weaken the demand and supply of quality audits, lessening their role as a bonding mechanism and a credible signal. Our empirical results provide support to the former view that Big Five auditors fulfill a stronger governance function in weaker legal environments.

Voluntary Disclosure in R&D-Intensive Industries*

Abstract: Disclosures about R&D activities could potentially help market participants understand the future prospects of R&D intensive firms, but at the same time could be costly to make if the disclosure is related to proprietary information. I examine R&D-related disclosures made by R&D intensive firms in their annual report, as well as throughout the year to financial analysts. I find that the level of R&D-related voluntary disclosure is higher when proprietary costs are lower and when the book to market ratio is lower, perhaps because the basic financial statements are less informative about market value. In addition, after controlling for the level of general disclosure and forward looking disclosure, I find a negative relation between disclosures about development stage R&D and both analysts' one-year-ahead sales forecast error and dispersion. This is consistent with disclosures about development stage R&D reducing analyst uncertainty about one-year-ahead sales. I find mixed evidence about earnings forecasts. A higher level of disclosure about both R&D projects in progress and development stage R&D is associated with less error in analysts' one-year-ahead earnings forecasts. However, I find no evidence of a relation between R&D-related disclosure and the dispersion in one-year-ahead earnings forecasts.

Information Asymmetry and Cross-sectional Variation in Insider Trading*

Abstract: This study investigates the relationship between insiders’ trades and a firm’s infor-mation environment. We address the basic question: Are candidate measures for thedegree of information asymmetry between a firm’s managers and other market par-ticipants associated with insiders’ trades in the manner predicted by theories ofinformed trading? Specifically, we analyze how six candidate measures of infor-mation asymmetry explain cross-sectional variation in insiders’ trades.Although some insiders’ trades are due to insiders’ liquidity and portfoliorebalancing objectives, a component of insiders’ trades is driven by insiders’ infor-mation advantage over other market participants.

Relations among Measures, Climate of Control, and Performance Measurement Models*

Abstract: Cause-and-effect relations among performance measures are alleged to be distinguishing features of performance measurement models (PMM), such as balanced scorecards. This study reports the evolution of the study of a PMM that was developed by a large U.S.-based company for its closely linked distribution channel. Motivated by the literature on PMM and causality, we report an analysis of linked performance measures for 31 quarters (1997 – 2005) and 31 business units. We find minimal statistical significance and no significant predictive ability in the model (i.e., no Granger causality), yet the company and its distributors express satisfaction with the model and with both company and distributor profitability. Reasoning that cause and effect was not the only explanation for scorecard success, we thoroughly analyze qualitative data for how managers perceived and used (a) the relations in the scorecard and (b) the climate of control intended and achieved in the organization through the scorecard. We find that the PMM’s logical and finality relations support the company’s climate of control. We also find qualitative evidence that the use of the PMM creates an effective climate of control. We tentatively conclude that effective management control does not require statistically significant cause-and-effect relations in a PMM when other factors create a strong climate of control.

Persuasive Communications: Tax Compliance Enforcement Strategies for Sole Proprietors*

Abstract: Tax systems such as those found in Canada, the United States, and the United Kingdom primarily rely on the notion of voluntary compliance by taxpayers, but, importantly, the threat of possible audit also serves to “encourage” voluntary tax compliance (Braithwaite 2003). Audits, however, are not without cost to tax administrations, and they may not be an optimal use of government resources for all taxpayers.1 Given limited resources, the tax agency will ultimately be constrained by the extent of audit enforcement strategies, and, as a result, alternative strategies need to be considered. Prior behavioral research using hypothetical cases and taxpayer self-reports has reported mixed results regarding the success of using persuasive communications to encourage compliant tax reporting (Hasseldine and Kaplan 1992; Hite 1989, 1997; Violette 1989). Critiques of that research often focus on the lack of generalizability to real taxpayer data. Few behavioral studies have been able to use actual taxpayer data (Schwartz and Orleans 1967; McGraw and Scholz 1988, 1991; Blumenthal, Christian, and Slemrod 2001). The results from these studies are inconsistent and could be a result of the differing research designs. The current study addresses some of those design issues by using brief, straightforward normative appeals (positive reasons why compliance is advantageous) and sanction appeals (appeals emphasizing the negative consequences of noncompliance) to test for behavioral responses on actual sole proprietors’ tax reports to the UK Inland

The Moderating Role of Competition in the Relationship between Nonfinancial Measures and Future Financial Performance

Abstract: The use of nonfinancial measures in management control systems of firms has generated considerable interest among practitioners as well as researchers. The principal rationale presented to justify the use of nonfinancial measures for performance evaluation has been that nonfinancial measures are leading indicators of financial performance (Kaplan and Norton 1992; Ittner and Larcker 1998b). Most studies that have examined the relationship between nonfinancial measures and financial performance have shown mixed results (Ittner and Larcker 1998a; Banker, Potter, and Srinivasan 2000; Amir and Lev 1996). The mixed results suggest that these relationships may be contextual (Kaplan and Norton 1992; Ittner and Larcker 1998b), which makes it important to understand the factors that moderate these relationships before using them in managerial decision making and incorporating them in management control systems. Lambert (1998) argues that customer purchasing behavior is affected by characteristics of the economic environment such as the level of competition. In this study we extend this argument to show that unless we recognize the competitive environment of business units we cannot understand the true relation between nonfinancial measures and financial performance. Emphasizing nonfinancial measures may make sense in locations with high levels of competition. However, the same may not be true where competition is limited and fewer choices exist for customers to shop and employees to work. This is because the lack of competition may result in higher switching costs for customers and employees who may need to travel a greater distance to transact with a new supplier or employer.1 We assess whether, and under what competitive conditions, the reporting of nonfinancial measures such as employee satisfaction and customer satisfaction is

Audit Committee, Board Characteristics, and Auditor Switch Decisions by Andersen's Clients*

Abstract: ** *Corresponding author. Please address all correspondence to Jian Zhou, School of Management, SUNY at Binghamton, Binghamton, NY 13902-6000; email: jzhou@binghamton.edu ; phone: (607) 777 6067. We thank two annoymous reviewers, Susan Albring, Jan Barton, Lou Braiotta, Shijun Cheng, Peter Clarkson (the Associate Editor), Randy Elder, Carol Ann Frost, Ross Fuerman, Jacqueline Hammersley, Henry Huang, Ryan LaFond, Bin Ke, Ling Lei, Shu-Hsing Li, Gerry Lobo, Linda Myers, Kannan Raghunandan, Sara Reiter, Steven Schwartz, Taychang Wang, Weimin Wang, Jay Wellman, Wei Zhang, X. Frank Zhang, Ping Zhou, Jerry Zimmerman, Jayanthi Krishnan (Discussant) and participants at 2004 American Accounting Association annual meeting and 2005 European Accounting Association annual congress, Yi-Tsung Lee (Discussant) and participants at 2004 Accounting Theory and Practice Conference at National Cheng-Chi University, and workshop participants at National Taiwan University and National Cheng Kung University for their helpful comments. We are also very grateful to Jan Barton for providing us with the media coverage data. Ken Y. Chen gratefully acknowledges the financial support of the National Science Council, Taiwan (Project No. NSC 92-2416-H-006-034). We thank Chih-Hui Cheng and Feixue Yan for their research support. ** The finial version of the paper is forthcoming in Contemporary Accounting Research. The main difference between this version and the final version is the deletion of the second and third contributions on page 3 and page 4 of this version. The accepted final version may not be posted on the ARN due to CAAA copyright restrictions.

Audit firm appointments, audit firm alumni, and audit committee independence

Abstract: A company officer is an "alumnus" if he previously worked for an audit firm. Iyer et al. (1997) find alumni have ties with their former audit firms and alumni are more inclined to provide economic benefits to former firms if they have stronger ties. If the alumnus is a senior corporate officer, the alumnus may benefit her former firm by recommending that the company appoints the firm as its auditor. However, the company's audit committee may be concerned that officer-auditor ties threaten audit quality. Therefore, an independent audit committee may not sanction the appointment of the officer's former firm. This study investigates whether: (1) companies tend to appoint officers' former audit firms, and (2) independent audit committees mitigate this tendency. We document that companies appoint officers' former firms more often than they appoint alternative audit firms. However, companies are less likely to appoint officers' former firms if audit committees are more independent. This suggests that independent audit committees strengthen audit quality by deterring affiliations between audit firms and officers.

The Stock Market Valuation of R&D Information in Biotech Firms*

Abstract: We assess whether a firm's research and development (R&D) expenditures, as well as uncertainty metrics that underlie their ultimate conversion into value, can significantly enhance the relevance of a valuation model based solely on traditional financial reporting variables and improve equity value predictions. We focus on the biotech industry during the 1998-2004 period and classify firms into emerging and mature categories to reflect their commercial maturity. The 1998-2004 period also comprises three distinct market cycles: a bubble (1998-99), a downturn (2000-2), and a rebound (2003-4). We first show that R&D expenditures are incrementally value-relevant over the baseline financial reporting model (book value and earnings). Also, the value-relevance of R&D expenditures is enhanced significantly by introducing uncertainty metrics as interaction terms. Second, the mapping into value reveals differential roles according to commercial maturity. We find that alliance networks and targeting high profile diseases have greater value-relevance for emerging firms. In contrast, the value of mature biotechs is more sensitive to drug development status and product diversification. Third, the mapping to value also differs across stock market cycles, with a tendency toward a return to fundamentals (financial and nonfinancial) as we move away from the 1998-99 bubble. Fourth, we find that adding R&D expenditures generally improves equity value predictive ability. Adding uncertainty metrics further improves predictions, with differences still prevailing across firms and stock market conditions. Both sets of R&D information make higher contributions to predictive accuracy in the case of mature biotechs, and results reinforce our view of a return to fundamentals, especially for these firms.

The Chief Financial Officer's Perspective on Auditor-Client Negotiations*

Abstract: Auditor-client negotiation about difficult client accounting issues involves both the auditor and the client. On the client side, the Chief Financial Officer (CFO) plays a central role in the financial reporting process, yet is rarely the focus of academic study. This paper reports how a sample of Canadian CFOs viewed the negotiation process and context, using an experiential questionnaire to build on the negotiation model developed and demonstrated for the auditor side of the negotiation by Gibbins, Salterio, and Webb 2001, and corroborated by a comparison of common questionnaire items across auditor and CFO samples by Gibbins, McCracken, and Salterio 2005. The CFOs saw negotiation with the auditors as a consequence of change in accounting and disclosure standards or personnel influential to their financial reporting, or business changes, such as, new business deals or acquisitions. Negotiation was thrust upon the CFO, and the CFO then had to manage it. The CFOs informed other management (such as the CEO) and was aware of their interests, but did not generally seek their help. Informing the Board or the audit committee of the issue was much less frequent. The issue being negotiated was seen as complex, requiring research and analysis, and dependent on knowledge and expertise, with the result more likely reflecting form over substance (a result some CFOs suggested was more agreeable to the auditor than to the CFO).

An Examination of Auditor Planning Judgements in a Complex Accounting Information System Environment

Abstract: This study investigates the effects of computer assurance specialist (CAS) competence and auditor accounting information system (AIS) expertise on auditor planning judgements in a complex AIS environment. Recent professional standards state that auditors need to change their audit strategies in reaction to the all-encompassing changes in their clients’ AIS (American Institute of Certified Public Accountants [AICPA] 2001, 2002). Information technology (IT) applications, such as enterprise resource planning (ERP) systems, are significantly changing the ways in which companies operate their businesses (e.g., business process reengineering) and auditors perform their duties (Helms 1999; Public Oversight Board [POB] 2000). For example, the implementation and utilization of ERP systems at many major corporations can increase audit-related risks such as business interruption, data base security, process interdependency, and overall control risk (Hunton, Wright, and Wright 2004). As technological developments continue, auditors must expand their AIS knowledge and skills in order to perform effective and efficient audits (POB 2000; Kinney 2001; AICPA 2002). Prior research suggests that expertise in the AIS domain may make auditors more cognizant of AIS-specific risks and provide them with the sophisticated audit skills required in such settings (Lilly 1997; Hunton et al. 2004). To our knowledge, our study is the first to examine whether auditors’ AIS expertise levels affect their risk assessments and subsequent testing decisions in a complex AIS setting. Statement on Auditing Standards (SAS) No. 94 (AICPA 2001) suggests that a CAS be assigned to assist in the audit of computer-intensive environments. CAS (also referred to as information systems audit specialists and IT auditors) provide

Do Auditor-Provided Nonaudit Services Improve Audit Effectiveness?*

Abstract: JENNIFER R. JOE, Georgia State UniversitySCOTT D. VANDERVELDE, University of South Carolina1. IntroductionIn recent years, there has been a heated debate over whether auditors should beallowed to provide any nonaudit services to their audit clients.' Public accountingfirms and other proponents of auditor-provided nonaudit services argue that perform-ing both audit and nonaudit services for the same client increases audit effectivenessand audit efficiency because it promotes a more comprehensive understanding ofthe client. For example, Terry Strange, global managing partner of KPMG, arguesthat "non-audit services enhance audit effectiveness" (cf. Norris 2000). However,opponents of auditor-provided nonaudit services, many of whom advocate a com-plete ban on such services, argue that acting in a dual capacity as auditor andconsultant/adviser compromises auditor independence and objectivity. Bazerman,Loewenstein, and Moore (2002) argue that the structural aspects of accounting andcharacteristics of human nature can cause unconscious bias in an auditor's judge-ments in the direction of the client's preferences. Bazerman et al. point out thatperforming nonaudit services for audit clients increases the auditor's attachment tothat client, leading to bias in judgement. Former Securities and Exchange Com-mission (SEC) chairman Arthur Levitt expresses a similar sentiment: "I think thatany kind of consulting in this environment makes the audit look at least in ques-tion" (cf. Revell and Burke 2003). Many users of audit reports also share this view.According to a survey of financial analysts, 83 percent of analysts believe that"objectivity is threatened even when the non-audit fee is less than the audit fee"(emphasis added) (SEC 2001).In this paper, we use an experiment to investigate (a) whether knowledgegained from working on a nonaudit task can be transferred to enhance the perfor-mance of audit tasks, and (b) whether any knowledge transfer can be achieved ifthe auditor only reviews the nonaudit workpapers prepared by nonaudit staff in thesame audit firm or a different audit firm. Thus, this study focuses on the cognitive

Letting the “Tail Wag the Dog”: The Debate over GAAP versus Street Earnings Revisited*

Abstract: A variety of alternative definitions and sources of actual earnings realizations are available to investors. In addition to “traditional” earnings numbers produced in conformity with generally accepted accounting principles (GAAP) and filed with the Securities and Exchange Commission (SEC), these alternative measures include the so-called Street earnings numbers that are based on proprietary definitions employed by commercial forecast data providers (FDPs). Increasing visibility of Street earnings in the 1990s gave rise to the hypothesis, articulated in the financial press and by government agencies and standard-setters, that firms, perhaps with the proactive or tacit support of FDPs, are using Street earnings to manipulate investor beliefs in a manner that leads to inflated stock prices (see, e.g., Levitt 1998; MacDonald 1999; Tergesen 1999). The hypothesis that Street earnings are inflated and lead to stock mispricing gained additional currency from some academic studies, which, among other things, provided evidence of stronger market reactions to Street versus GAAP earnings-based surprises (e.g., Bradshaw and Sloan 2002; Doyle, Lundholm, and Soliman 2003; Bagnoli, Eskew, and Watts 2001). A competing view has emerged which posits that evidence of stronger market reactions to Street earnings surprises reflects the fact that Street earnings are generally more informative than GAAP earnings, and thus rational investors prefer to rely on these earnings to make their investment decisions (e.g., Brown and Sivakumar 2003).

The Effects of Perceived Fairness on Opportunistic Behavior

Abstract: The classic agency model provides the basis for a large number of organizational contracts in the contemporary business environment. However, contracting provisions based on this model may induce undesirable behavior and shifts in employee value systems. Therefore, we expand upon the agency model by exploring fairness as a motivator of positive behavior in the contracting environment. Managers were asked to make a cost allocation decision in which we manipulated information asymmetry (absent or present) and incentives (absent, low, or high). Results indicate that subjects’ perception of the fairness of the action dominates the agency effect in determining the intent to act opportunistically. Further analysis suggests that, among subjects who perceive that the action is unfair, the inclination to behave opportunistically is insensitive to the size of the incentive to do so. We conclude that researchers and managers should consider fairness as an important element of the opportunity-incentive-action dynamic when the need for contracting around potential agency problems arises.

Accountants' Usage of Causal Business Models in the Presence of Benchmark Data: A Note*

Abstract: Accepted by Steve Salterio. We gratefully acknowledge the helpful comments and suggestions of Steven Salterio (editor), two anonymous reviewers, Joan Luft, and Dave Ricchiute. We are also grateful to Joanna Ho, Kathryn Kadous, Khim Kelly, Bill Kinney, Ella Mae Matsumura, Lisa Sedor, participants at the 2005 Global Management Accounting Research Symposium, and participants at the 2004 Auditing Midyear Research Conference for their helpful comments on previous versions of this manuscript. The authors are indebted to the auditors who participated in the experiment, and to the Master of Science in Accountancy students who participated in the pilot study. Professor Vera-Munoz acknowledges financial support by KPMG LLP through its Faculty Fellowship program.

How Do Underwriters Value Initial Public Offerings? An Empirical Analysis of the French IPO Market*

Abstract: textThis paper investigates how French underwriters value the stocks of companies they bring public. Underwriters often use several valuation methods to determine their fair value estimate of the initial public offering (IPO) firm's equity. We investigate five of these valuation methods: peer group multiples valuation, the dividend discount model, the discounted cash flow model, the economic value-added method, and underwriter-specific methods. We document that underwriters base their choice for a particular valuation method on firm characteristics, aggregate stock market returns, and aggregate stock market volatility in the period before the IPO. In addition, we examine how underwriters combine the value estimates of the valuation methods they use into a fair value estimate by assigning weights to these value estimates. We demonstrate that these weights also depend on firm-specific factors, aggregate stock market returns, and aggregate stock market volatility. Finally, we show that underwriters discount their fair value estimate to set the preliminary offer price of the shares. This discount is higher for IPO firms with greater valuation uncertainty and lower for companies that are brought to the market by more reputable underwriters and that are forecasted to be more profitable.

Concentration in Publishing at Top‐Tier Business Journals: Evidence and Potential Explanations*

Abstract: We first investigate how articles are distributed among universities in a set of 14 highly ranked academic business journals over the period 1990-2002. We find the top publishing schools in accounting and finance supply a greater portion of their discipline's major journal articles than in management or marketing. Much of the concentration in accounting occurs at privately sponsored journals, where faculty at private (public) schools publish a relatively high (low) portion of the articles. Next, we investigate how articles are distributed among individuals. We find the following: substantially fewer accounting faculty publish in a major journal; the average number of articles by accounting faculty who publish at least once exceeds that of finance, management or marketing; and successful accounting publishers are more likely to be affiliated with highly ranked research universities or private schools. Finally, we examine if economic consequences arise from this concentration and find evidence of lower promotion rates and salary increases for accounting full professors.

Effects of Qualitative Factor Salience, Expressed Client Concern, and Qualitative Materiality Thresholds on Auditors' Audit Adjustment Decisions*

Abstract: We conduct an experiment to provide evidence on factors that influence auditors' propensity to book or waive audit differences that affect the client's ability to meet the analysts' consensus forecast and avoid a negative earnings surprise. Results indicate that increasing the salience of a qualitative materiality factor (by highlighting the audit difference's impact on the client's ability to meet the analysts' consensus forecast) increases auditors' propensity to book the audit difference, but only for auditors with lower qualitative materiality thresholds (i.e., the thresholds that auditors use to assess qualitative materiality). Further, the presence of expressed client concern about the adverse consequence of booking the audit difference is found to attenuate the effect of increased salience of the qualitative factor for these auditors. These findings contribute to a better understanding of why auditors may (or may not) waive quantitatively immaterial but qualitatively material audit differences, and the boundary conditions under which mechanisms for enhancing auditors' audit adjustment decisions work (or may not work).

Measuring Customer Relationship Value: The Role of Switching Cost*

Abstract: Conceptually, customer relationship value depends on customer perceptions of the cost of switching to another supplier. Empirical tests of switching cost effects have been hampered because traditional performance measurement systems and customer satisfaction scores do not reflect switching cost perceptions within comparable market segments across firms. Using unique data systematically collected by market segment from online retail customers, we find that a) our switching cost proxy adds statistically significant explanatory power for both future buyer behaviors at the segment level and future financial performance at the firm level, and b) the positive relation between customer attitudes and future buyer behavior is increasing in switching cost. Our results show that externally generated non-financial data collected periodically across market segments can individually and jointly provide valuable information about segment and consolidated entity performance.

Accuracy in Judging the Nonlinear Effects of Cost and Profit Drivers

Abstract: Managers often make judgments about cost-driver and profit-driver relations using subjective analysis rather than statistical analysis of accounting data. We provide theory-consistent experiment evidence that, even when the strength and temporal contiguity of the relation between financial performance and its driver are held constant, the prediction task is relatively simple, and individuals have relevant training and experience, individuals' differing mental representations of the cost-driver and profit-driver relations result in significantly different judgment accuracy. In the experimental setting in this study, judgment accuracy is higher when performance is measured as cost rather than profit. Judgment accuracy tends to be higher for more direct relations, and individuals mentally represent the cost-driver relation in the experimental task as a more direct causal chain than the profit-driver relation. We present supplementary evidence supporting the theory that accounting prompts individuals to adopt cause-and-effect mental representations of varying directness between performance measures, rather than attending only to the sign and strength of the relation. Thus, an important consideration in the choice of performance measures should be cognitive properties as well as statistical properties of the measures - in particular, the directness of the cause-and-effect mental representation that the performance measures prompt.

Capital Gains Taxes and Acquisition Activity: Evidence of the Lock-in Effect*

Abstract: The lock-in effect proposes that capital gains taxes represent transaction costs that increase the reservation price for security owners and, ceteris paribus, reduce trading volume. Consistent with the lock-in effect, previous empirical research documents price and volume reactions to enacted changes in the capital gains tax rate. We investigate whether the “volume hypothesis” predicted by the lock-in effect extends to corporate acquisition activity. In particular, we analyze whether aggregate corporate acquisition activity is inversely associated with shareholder capital gains tax rates. We measure quarterly corporate acquisition activity from 1973 through 2001 using (1) the percentage of publicly traded firms acquired in a calendar quarter and (2) the percentage of market value of publicly traded firms acquired in a calendar quarter. In supplemental analysis, we measure acquisition activity at the industry level (i.e., as the percentage of firms and percentage of market value acquired by industry in each year). In each analysis we model acquisition activity as a function of the maximum long-term capital gains tax rate for individuals and other macro-economic factors previously hypothesized to be associated with acquisition activity. Consistent with a lock-in effect for corporate acquisitions, we find a significant negative association between corporate acquisition activity and the capital gains tax rate whether we measure acquisition activity in the aggregate or at the industry level. In addition, we find that this negative association is attributable to increased (decreased) taxable acquisition activity during periods of low (high) capital gains tax rates. These results suggest that, ceteris paribus, capital gains taxes represent significant transaction costs or market frictions that influence the level of corporate acquisition activity.