Showing papers in "Journal of Accounting Research in 1985"

Disclosure of Nonproprietary Information

Abstract: In this paper, I provide two theories about why management might withhold information which is not proprietary, together with an analysis of the consequences of altering various assumptions underlying these theories. Proprietary information is considered here as any information whose disclosure potentially alters a firm's future earnings gross of senior management's compensation.' Even if a manager's private information is proprietary, shareholders may benefit occasionally from having this information disclosed (see Verrecchia [1983] and Dye [1984a]), although obvious explanations exist for the rarity of such disclosures. However, it is commonly believed that managers possess information about the firms they run, such as annual earnings' forecasts, whose release would affect the prices of their firms, but not the distribution of their firms' future

Predisclosure Information, Firm Capitalization, and Security Price Behavior Around Earnings Announcements

Abstract: Several studies on the relationship between earnings reports and security price behavior provide evidence suggesting that a significant portion of the information revealed through earnings reports is reflected in security prices prior to the report month (e.g., Ball and Brown [1968] and Brown and Kennelly [1972]). This has been attributed (at least partly) to the existence of other more timely sources of information which allow market agents to forecast earnings prior to their release. The evidence above reflects an "average finding" across all firms. One question of interest is whether there are significant systematic crosssectional differences in the security price reactions to earnings announcements of firms which are associated with specific firm characteristics that lead to differential amounts of predisclosure information. This study focuses on firm size (capitalization) as one such characteristic.' A "firm

Amortization Policy for Advertising and Research and Development Expenditures

Abstract: Several reasons exist for differences between the value of the firm reflected by stock market values and the historical value reported in accounting financial statements. One major one is that financial statements are limited to those items that meet the present-day recognition criteria employed by the accounting profession. Thus, potentially relevant items such as advertising and research and development (R&D) are not reported on balance sheets because they do not meet the qualitative criterion of reliability. To date, little empirical evidence exists to support an intangible capital treatment of advertising and R&D, much less provide any information as to how their capitalized values might be amortized (for a notable exception, see Peles [1970]). Indeed, in Statement of Financial Accounting Standards No. 2, the FASB took the position that practically all R&D should be expensed as incurred. Although no formal reporting standard exists on the proper accounting for advertising expenditures, its accounting treatment is similar to that employed for R&D. Nevertheless, the definition of assets developed in Statement of Financial Accounting Concepts No. 3 suggests that, in some cases, advertising and R&D could be capitalized. In addition, recent work on recognition criteria as part of the conceptual framework project suggests there may be new ways of reporting these types of items. This paper considers the advertising and R&D expenditure treatment

Participative Budgeting: The Effects of Risk Aversion and Asymmetric Information on Budgetary Slack

Abstract: A number of behavioral studies have attempted to determine the kinds of influences participative budgeting has on such aspects as a subordinate's job satisfaction and job performance. Participative budgeting allows a subordinate to bring his1 information to the task of specifying standards of performance and as such may lead to higher job performance and higher job satisfaction. The evidence is generally mixed on the former, but reasonably consistent on the latter (Locke and Schweiger [1979]). The existence of information asymmetry on the part of subordinates has recently gained importance in agency theory, where concern is focused on obtaining true revelations of subordinates' inside information (e.g., see Baiman [1982] and Christensen [1982]). The problem is that the existence of private information coupled with participation may give rise to situations in which subordinates intentionally build excess

Earnings Volatility and Voluntary Management Forecast Disclosure

Abstract: In this paper I report the findings of an empirical investigation of the association between firms' earnings volatility and the timing and frequency of management earnings forecasts. Such a relationship might be expected if earnings volatility is associated with either the costs or benefits to executives in publicly disclosing such projections. A potential cost-related interpretation is that managers of firms with more volatile earnings are reluctant to disclose their forecasts due to increased exposure to costs (e.g., legal sanctions) associated with unattained projections. A benefit-related interpretation might be that managers perceive benefits from issuing forecasts which improve the projections of individuals (e.g., security analysts) external to the firm. To the extent that informativeness of forecast information is related to management's ability to generate accurate projections, then an association between volatility and forecast disclosure frequency might be expected. Recent survey evidence by Lees [1981] suggests that both of these factors appear to be consistent with stated executive preferences about voluntary forecast disclosure. Further

On the Use of the Multivariate Regression Model in Event Studies

Abstract: A Multivariate Regression Model (MVRM) methodology to measure the effect of new information on asset prices was first suggested in Gibbons [1980, appendix H]. In this paper I outline the use of that methodology to measure abnormal returns and to test hypotheses about these returns. Included are advantages of the MVRM methodology over other event study methodologies and some of its problems in hypothesis testing.1 Section 2 discusses the MVRM technique relative to better-known methodologies. In section 3 I compare these methodologies and argue that the primary advantage of the MVRM is in testing joint hypotheses. Section 4 provides small sample evidence on several test statistics used in the MVRM; section 5 summarizes the paper.

Classifying Bankrupt Firms with Funds Flow Components

Abstract: In their review of bankruptcy studies, Ball and Foster [1982] point out that such studies typically used a brute empiricism approach to choose the independent variables (financial ratios) for their models. Since an underlying theoretical rationale was not used to justify the selection of significant ratios, the empirical findings tended to be sample specific and not capable of indicating the most likely predictors of financial distress. As a step toward overcoming this shortcoming we chose a cash-based funds flow model developed in 1972 by Helfert [1982] and suggested in the FASB Exposure Draft [1981] as the basis for our study of bankruptcy prediction. The primary objective of this study is to test such a model by assessing whether cash-based funds flow ratios can adequately classify failed and nonfailed companies and serve as an alternative to financial ratios computed using accrual accounting. As such, our study complements the one by Casey and Bartczak [1985] which investigates cash flow from operations. Our logit findings substantiate Casey and Bartczak's findings that cash flow from operations does not improve the classification results of failed and nonfailed companies. Additionally we found the dividend funds flow component in a logit model was significant in distinguishing between failed and nonfailed companies. In the next section we introduce a cash-based funds flow model to be used for classification purposes. The selection of the companies to be

A Multivariate Analysis of the Auditor's Going-Concern Opinion Decision

Abstract: The Auditing Standards Board (ASB) recently attempted to eliminate the subject-to opinion, including those issued for going-concern uncertainties. Financial statement users expressed strong opposition to this move, partly because they believed that auditors are privy to inside information (AICPA [1982; 1983]). Clearly, if an auditor's loss-likelihood judgment is made with greater precision because of access to inside information, the audit opinion would have information content. On the other hand, if auditors' opinions merely reflect what can be gleaned from publicly disclosed information, then the opinion itself could be redundant.' The research described in this paper was designed to examine the relationship beween the going-concern opinion and publicly available information. Discriminant analysis was used to test models of the goingconcern opinion decision with a sample of manufacturing companies that received a going-concern opinion (GCAR companies) and a sample of manufacturing companies that exhibited potential going-concern diffi-

Using Operating Cash Flow Data to Predict Financial Distress: Some Extensions

Abstract: Recently, financial statement users and regulators of publicly reported financial accounting data have argued in favor of the disclosure of detailed information on firms' current operating cash flows (Harris et al. [1980], FASB [1981], Smith [1982], and Thomas [1982]). The FASB suggests that such disclosures will allow users to assess better the amount, timing, and uncertainty of future cash flows. It states that "the greater the amount of future net cash inflows from operations, the greater the ability of the enterprise to withstand adverse changes in operating conditions" [1981, p. 11]. The presumption that historical operating cash flows enable better assessments of future cash flows, however, is based on intuition rather than on empirical evidence (Griffin [1982]). Our study was conducted to assess whether operating cash flow data and related measures lead to more accurate predictions of bankrupt and

Using Citation Analysis to Assess the Impact of Journals and Articles on Contemporary Accounting Research (CAR)

Abstract: Citation analysis has been used in the natural and social sciences for such purposes as evaluating the research contributions of articles, journals, institutions, and individuals (Garfield [1979]). Some specific applications of the technique to the social sciences include measuring the exchange of information within the management sciences (Back [1974]), predicting Nobel Laureates in economics (Quandt [1976]), appraising journals in psychology (White and White [1977]), evaluating the impact of marketing scholars and academic institutions (Robinson and Adler [1981]), and assessing the relative impacts of economics journals (Liebowitz and Palmer [1984]). Citation analysis has also been used on two occasions in the accounting discipline by McRae [1974] and Dyckman and Zeff [1984], but for somewhat more specific purposes than assessing contributions to accounting research in general. For example, McRae [1974] attempted to define the accounting information network based on a citation analysis of the flow of messages

Availability and the Generation of Hypotheses in Analytical Review

Abstract: In a typical highly structured study of audit decision making, the auditors (judges) are presented with a small number of cues and are required to combine the cues into a response on a predetermined numerical scale (e.g., Ashton [1974] and Joyce and Biddle [1981]). The structure of this type of task and the subjects' passive role permit their behavior to be appropriately modeled by a simple cue combination rule, as in the lens or probabilistic judgment models. However, as Einhorn [1976] suggested, a great many accounting decision tasks are ill-structured. In these situations, the judge takes a more active role, generating as well as confirming or disconfirming hypotheses, and searching for and evaluating information. Einhorn describes these kinds of accounting decision situations as diagnostic problems and suggests a general framework for their analysis. The framework portrays the diagnostician-accountant facing a company with certain unusual symptoms. In attempting to determine the reasons for the symptoms, the diagnostician typically searches for further information. According to Einhorn, the critical question is: "Where does he start looking, that is, how is his search activity directed so that it is not chaotic?" He goes on to suggest that: "Without some sort of hypothesis, search cannot be

Budgetary Systems and the Control of Functionally Differentiated Organizational Activities

Abstract: Considerable attention has been given to the question of the role of budget systems in the control of organizations which differ in terms of characteristics such as size, structure, and diversity (Bruns and Waterhouse [1975] and Merchant [1981]). By contrast, little attention has been directed to the broader question of how characteristics of different functional activities within the organization-e.g., marketing versus R&D-influence the effectiveness of control strategies such as the degree of participation in budget setting and the reliance placed on accounting information in control. Of course, the two questions are related in that differing functional activities are typically structured differently in response to various environmental determinants, and this in turn will influence the choice of controls to be used in each. This paper reports the results of an empirical investigation in which the marketing and R&D units of a large electronics firm were compared in terms of both the environmental conditions they face and the effects of their control system choices on managerial performance within the two functional areas. The results provided limited support for predicted

Strategic Accounting Choice and the Effects of Alternative Financial Reporting Requirements

Abstract: In this paper, I evaluate the effects of mandatory changes in accounting standards on firms' disclosure decisions. Several issues are addressed, including the relation between mandatory reports and voluntary disclosures, the effects of imposing "consistency" in accounting choice, the consequences of increasing firms' discretion in accounting procedures, and the implications of requiring firms to issue "more detailed" accounting reports. The analysis of each of these issues depends critically on the firm's motivation for choosing among financial reporting techniques. Throughout this paper, I assume that a firm's choice among reporting requirements is influenced by how that choice alters its ability to protect its proprietary information. Since this is not a common assumption, some comment on its appropriateness is warranted. One of the limitations of most discussions of mandatory accounting reporting procedures is that these discussions give little attention to firms' incentives not to disclose information voluntarily. This results in a Catch-22. If firms have no incentives to withhold their information, then analyses of the amount of information produced by various mandatory reports are moot, since any information not supplied in mandatory

Vertical Information Transfers: The Association between Retailers' Sales Announcements and Suppliers' Security Returns

Abstract: Accounting research has documented an association between the occurrence of at least some types of disclosures made by a firm (e.g., earnings announcements, accounting changes, or capital structure changes) and that firm's security return. As yet, however, there is little evidence about the relation between information disclosures made by one firm and security prices of other firms, although cross-sectional relations among security prices, sometimes described as industry factors, are well documented (e.g., King [1966], Schipper and Thompson [1983], and Smith [1981]). One possible explanation for this cross-sectional association is that information disclosures made by one firm may provide relevant information about other firms. Recently, Foster [1981] examined the impact of earnings announcements on the security prices of other firms in the same industry. Foster documented statistically significant security returns for nonannouncing firms in ten industries at the time of "large" security returns for announcing firms within the same industry. These "intraindustry information transfers" suggest news releases of other firms within an industry are used in the determination of a given firm's security price.

Measuring Executive Compensation: Methods and an Application

Abstract: This paper describes methods for estimating the value of the total annual compensation of top corporate executives. These methods refine those originated by Burgess [1963], Lewellen [1968], and Masson [1969]. Measures of executive compensation are relevant in addressing three current issues. First is the extent to which the compensation effects of different accounting alternatives influence executives' preferences over proposed changes in accounting regulations and their actual selection of financial reporting techniques. Second is whether compensation effects of new financial reporting standards induce managers to change their production and investment decisions. Third is the impact of a change in the terms of executives' compensation contracts on their decisions.'

The Impact of Merger-Related Regulations Using Exact Distributions of Test Statistics

Abstract: In Schipper and Thompson [1983] (henceforth ST), we estimated a pooled cross-section, time-series model of the return-generating process for the common stock in a sample of related firms. Some of the test statistics reported, based on linear constraints across estimated coefficients, are quadratic forms in the sample covariance matrix. Under the structure and assumptions of the model, these test statistics have asymptotic chi-squared distributions (as the number of time-series observations goes to infinity). In that paper, we did not discuss the exact distributions of these test statistics. In this paper, we show that under the assumption of normality of residuals, the test statistics reported in ST involving asymptotic chisquared distributions have convenient finite sample distributions which can be used to test some of the hypotheses examined there.1 In doing so we reaffirm that the average impact on shareholder wealth of the Williams Amendments was negative and statistically significant for the

The Reliance of External Auditors on the Internal Audit Function

Abstract: The increased use of internal auditing (IA) by client firms leads to the possibility that external auditors will increasingly rely on IA in conducting their audits (Ward and Robertson [1980]), particularly as the quality of IA increases over time. According to Statement on Auditing Standards (SAS) No. 9, the decision to rely on IA should be preceded by an evaluation of the IA function: "The independent auditor should acquire an understanding [emphasis added] of the internal audit function as it relates to his study and evaluation of internal accounting control. The work performed by internal auditors may be a factor in determining the nature, timing, and extent of the independent auditor's procedures" (AICPA [1975]). Although SAS No. 9 provides guidelines on the characteristics of IA that might affect auditors' evaluations' and subsequent decisions to rely on clients' IA functions, it does not suggest their relative importance. According to SAS No. 9, the three primary factors affecting the evaluation and reliance decisions are internal auditors' competence, objectivity, and work. The objective of this research was to determine both the extent to which auditors would rely on the IA function, and the relationship between their reliance decisions and their evaluations of IA strength. Included in the investigation was an assessment of the levels of impor-

The Effect of the Review Process on Auditor Judgments

Abstract: Most public accounting firms have well-defined review procedures which require the work carried out by each auditor to be reviewed by staff with higher levels of experience (expertise). The importance of this review process is frequently emphasized in the auditing literature. Indeed, Statements on Auditing Standards (AICPA [1981, sec. 230.02]) state that the "exercise of due care requires critical review at every level of supervision of the work done and the judgment exercised by those assisting in the examination." Despite the stated importance of this review process in auditing, there is little empirical evidence on its effectiveness. Previous research on auditors' judgments has primarily considered individual judgments (for example, see reviews by Libby [1981] and Ashton [1982]) although suggestions have been made to consider decisions by both interacting groups and those resulting from the review process (for example, see Joyce [1976]). A number of recent studies (Schultz and Reckers [1981], Solomon [1982], and Trotman, Yetton, and Zimmer [1983]) extended this earlier work by examining the judgments of interacting groups of auditors. However, these studies did not capture the hierarchical and sequential nature of the review process. Although in practice, the review process may take a number of forms, we adopted the procedure of having managers review seniors' work in

Information Content and the Speed of Stock Price Adjustment

Abstract: The process by which security prices adjust to the release of "new" information is an area of study which has received much attention in accounting and finance. In finance, the main interest has been whether prices adjust in a rapid and unbiased manner to new information. In accounting, the focus has been more on whether different accounting disclosures have information content. The study reported here combined both interests in that we investigated the speed of adjustment of releases of information which had different degrees of information content. As illustrations, Dann, Mayers, and Rabb [1977] tested the sensitivity of a block-trade trading rule to the speed of price adjustments. This rule (first suggested by Grier and Albin [1973]) is based on the assumption that abnormal returns can be earned by purchasing shares at the block price and selling at that day's closing price. Dann, Mayers, and Rabb (hereafter DMR) found that unless one could purchase the stock within five minutes of the block trade the profitability of the Grier and Albin rule was seriously impaired. They also found the market price to be an unbiased estimate of the closing price within 15 minutes of the block trade. Similarly, Hillmer and Yu [1979] devised an alternative test for the speed of price adjustment based on a cumulative sum technique. They illustrated the technique by testing for shifts in the parameters of the distributions of price changes and of transaction frequencies around five information events-two earnings announcements and three defense

The Review Process and the Accuracy of Auditor Judgments

Abstract: The review process is an integral part of the standard operating procedures of audit firms. While its importance has been noted (for example, see Mautz and Sharaf [1961] and AICPA [1981 sec., 320.02]) there has been little research or discussion on this review process (Bamber and Bylinski [1982]). One exception is Trotman and Yetton [1985] (hereafter TY) who examined the effect of the review process on the consensus of internal control evaluations. They found that although the level of consensus was significantly improved by the use of the review process, similar improvements could be obtained by the use of an interacting or composite group. TY suggested that the addition of a second opinion, regardless of its form, seemed to improve "performance." Consistent with most previous studies on internal control judgments in which no criterion variable is available, TY used consensus as a surrogate for accuracy. However, as they noted, consensus is only a reasonable surrogate for accuracy if the expected value across all judges is an unbiased estimate of the correct judgment. Otherwise, group and/ or review processes may simply suppress outliers, thereby inflating consensus without a corresponding increase in accuracy. The main objective of the present study was to overcome this limitation by examining accuracy instead of consensus. This examination of the

Accounting Earnings and Security Valuation: Empirical Evidence of the Fundamental Links

Abstract: Considerable accounting research has been devoted to analyzing the relation between accounting data and contemporaneous security prices. A conceptual framework that explains this relation is provided by the information perspective on accounting. This framework involves an information link, between accounting data and the future stream of benefits from an equity investment, and a valuation link, between the future benefits and security price.1 The aim of this paper is to provide empirical evidence of these fundamental links. In a world with rational wealth-maximizing investors, security price is generally regarded as being tautologically equal to the present value of expected future benefits of share ownership. The contemporaneous association between accounting earnings and security price is therefore a

An Empirical Investigation of Stockholder Reaction to Disclosures Required by ASR No. 250

Abstract: The Securities and Exchange Commission (SEC) adopted Accounting Series Release No. 250: Disclosure of Relationships with Independent Public Accountants effective September 30, 1978 (SEC [1978a]). This release generally required public companies to disclose in their proxy statements (1) the percentage of fees for nonaudit services in relation to the audit fee (and percentage of fees for each nonaudit service in relation to the audit fee if the percentage exceeded 3%), and (2) whether the board of directors or its audit committee approved such services. This rule remained in effect until February 1982, when it was withdrawn because an SEC staff study found few companies reporting "sensitive" nonaudit services, and the SEC Practice Section of the AICPA Division of Firms subsequently required member firms to furnish information on the relationship of nonaudit fees to total fees for all SEC clients. Two aspects of the ASR No. 250 disclosures are of interest. The first is whether stockholders would perceive information regarding nonaudit services as a negative reflection on the independence of the auditor. The second (somewhat related) is whether in response to, or in anticipation of, stockholder reaction, managers and auditors changed the mix and/or extent of nonaudit services. In this study, we examined whether ASR No.

Corporate Management Lobbying on FAS No. 8: Some Further Evidence

Abstract: On December 31, 1974, the Financial Accounting Standards Board (FASB) issued an exposure draft for Statement of Financial Accounting Standards (FAS) No. 8, Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements. The intent of the standard was to bring uniformity to accounting for the translation of foreign currency transactions and foreign subsidiaries. Firms were required to use the temporal method of translation and to include unrealized foreign exchange gains and losses in income. Most managements expected this latter provision to increase the volatility of their reported earnings. The study reported in this paper examined the extent to which firms' debt contracts and managements' degrees of ownership in their firms were associated with managements' decisions to lobby the FASB in the form of comment letters regarding the proposed standard. Managements' lobbying activities provide a basis for predicting the consequences of a proposed accounting policy change on firms. That is, lobbying positions can assist the FASB in assessing potential opposition to a standard, as well as subsequent attempts to circumvent reporting requirements, subvert the standard, and/or discredit the policymaker. The issue studied

The Effect of LIFO-Switching and Firm Ownership on Executives' Pay

Abstract: Accounting research on choices of inventory valuation methods has focused on various consequences of two extreme methods: LIFO and FIFO. The main consequence studies relate to effects of the differences in taxes payable between the two methods on security prices. However, tax consequences appear to provide an incomplete explanation for managerial decisions to stay on FIFO or to change to LIFO. In this paper, I provide an analysis of another possible incentive of executives to stay on FIFO despite the apparent tax advantages of switching to LIFO.1 In

The Standard of Objectivity for Internal Auditors: Memory and Bias Effects

Abstract: Internal auditors perform many functions regarding internal control systems, and these may include assisting in the actual design of internal control systems. This could lead to situations in which the internal auditor subsequently audits an internal control system that s/he helped to design. The objective of this study was to investigate whether, and how, this dual role can affect the objectivity of the internal auditor's judgment. The Standards for the Professional Practice of Internal Auditing describe the standards of independence and objectivity as follows: "Independence permits internal auditors to render the impartial and unbiased judgments essential to the proper conduct of audits. It is achieved through organizational status and objectivity" (Institute of Internal Auditors [1978, sec. 100.01]). At the same time, the standard acknowledges that "objectivity is presumed to be impaired when internal auditors audit any activity for which they had authority or responsibility. This impairment should be considered when reporting results" [1978, sec. 120.02]. Although it may be desirable to avoid situations in which internal auditors review their own previous nonaudit work, the fact that internal audit staffs are often small and highly specialized makes this an imprac-

Choice of Inventory Accounting Methods: Comparative Analyses of Alternative Hypotheses

Abstract: In the past decade, hundreds of firms switched to the LIFO accounting method for their inventories in response to high rates of inflation. Nevertheless, many others continue to use the FIFO method. Biddle [1980] estimated that each of the 105 FIFO firms in his study paid an average of nearly $26 million in additional federal income tax. What makes these FIFO firms so reluctant to switch accounting methods? A review of the literature provides three possible explanations for inventory accounting choices: political costs, agency costs, and divergent production and investment characteristics. Because the required economic variables to test these three alternative explanations are not observable, the empirical tests are based on examination of proxy variables. Many of the proxy variables of the first and third explanations are the same, so it is difficult to discriminate one from the other using univariate statistical methods. For example, there is consistent evidence of an association between size and inventory accounting choices. But size can serve as a proxy for either political costs, or divergent production and investment opportunities, or both. Similarly, there is also strong evidence that the type of industry is associated with inventory choice, which could also be consistent with both explanations. The major purpose of this paper is to test the three explanations cited above in a simultaneous manner using multivariate probit methods.

A behavioral-study of the meaning and influence of tax complexity

Abstract: Complexity has been linked to the quality of an income tax system (Dean, Keenan, and Kenney [1980]), including its possible influence on the system's ability to generate revenues (New York State Bar Association [1972]). Given the IRS' recent estimate that $81 billion in annual revenue is lost through noncompliance (IRS [1983, p. 21]), the question of whether tax complexity has a significant effect on taxpayers' reporting positions is a potentially important issue. Complexity represents but one strand in a web of interrelated factors and propositions influencing compliant tax reporting in a democratic society. Nevertheless, it has been singled out as a factor affecting compliance and a study of its effect thereon can be viewed as one step in an ongoing program of study of noncompliance. This study involved two distinct phases. The first phase was devoted to obtaining operational definitions of tax complexity, using multidimensional scaling. These definitions of tax complexity were then used in the second phase of the study to test for potential effects of complexity on reporting position selections in four different tax situations. While phase 1 is critical to phase 2 of my study, this paper highlights the results of the latter. Details of phase 1 can be obtained in Milliron [1984]. In section 2 I discuss previous literature involving tax complexity. Section 3 provides an overview of the methodology and the research issues studied. Sections 4 and 5 describe the data collection procedures