Showing papers in "Journal of Accounting Research in 1991"

Earnings Management During Import Relief Investigations

Abstract: This study tests whether firms that would benefit from import relief (eg, tariff increases and quota reductions) attempt to decrease earnings through earnings management during import relief investigations by the United States International Trade Commission (ITC) The import relief determination made by the ITC is based on several factors that are specified in the federal trade acts, including the profitability of the industry Explicit use of accounting numbers in import relief regulation provides incentives for managers to manage earnings in order to increase the likelihood of obtaining import relief and/or increase the amount of relief granted While studies of earnings management typically examine situations in which all contracting parties have incentives to "perfectly" monitor (adjust) accounting numbers for such manipulation, import relief investigations provide a specific motive for earnings management that is not

Earnings as an explanatory variable for returns

Abstract: In this paper we investigate whether the level of earnings divided by price at the beginning of the stock return period is relevant for evaluating earnings/returns associations.' The primary model motivating this research relies on the idea that book value (owners' equity) and market value are both "stock" variables indicating the wealth of the firm's equity holders. The related "flow" variables (after adjusting for dividends) are, respectively, earnings divided by price at the beginning of the return period (A/P-1) and market returns. It then follows that earnings divided by beginning of period price should be associated with stock returns. Although models based on a relation between market value and book value are used occasionally in the accounting research literature (see, for example, Landsman [1986], Harris and Ohlson [1987], and Barth

Trading Volume and Price Reactions to Public Announcements

Abstract: The purpose of this study is to investigate theoretically how the price and volume reactions to a public announcement are related to each other, to the announcement's characteristics, and to the traders' beliefs at the time of the announcement. Among many possible sources of (abnormal) trading volume at the time of a public announcement, our emphasis in this study is on differences in the quality of preannouncement information. The study uses a two-period rational expectations model. Traders achieve their optimal portfolios prior to the announcement by trading on what each knows in the preannouncement period. The public announcement changes traders' beliefs and induces them to engage in a new round of trade. It is assumed that traders are diversely informed and differ in the precision of their private prior information; they therefore respond differently to the announcement, and this leads to positive volume. We obtain three results. First, the price change at the time of announcement is proportional to both the unexpected portion of the announcement and its relative importance across the posterior beliefs of traders. This relative importance is increasing in the precision of the announcement and decreasing in the precision of the preannouncement information.

Portfolio Considerations in Valuing Executive Compensation

Abstract: This paper analyzes the valuation of a compensation contract from a manager's perspective. This perspective is appropriate, for example, in research on the incentive effects of a compensation plan, because such effects are determined by how the manager's actions affect his valuation of his compensation. In contrast, in a study of the cost-effectiveness of a compensation plan, the shareholders' perspective is appropriate. Measuring the value to a manager of his compensation is difficult because some of the diverse components of compensation packages (e.g., executive stock options and restricted stock) have payoffs that are uncertain when the compensation is granted. In most empirical studies, each component is valued independently (without consideration of the structure of the compensation package as a whole), and these values are summed. Moreover, the values are frequently determined using formulas for publicly traded securities with "similar" payoff structures (i.e., from the perspective of security market participants). Market imperfections create divergence between managers' and shareholders' valuations of a component of a compensation scheme. In particular, moral hazard and adverse selection issues cause shareholders to tie

The Financial and Market Effects of the SEC's Accounting and Auditing Enforcement Releases

Abstract: This paper explores three questions related to the SEC's accounting enforcement program: (1) what types of accounting and auditing problems motivate enforcement actions, (2) what are the consequences of investigations on targets' financial statements, managers, and auditors, and (3) how do investors and other market agents view the SEC's actions? The SEC enforcement program, which consists of investigations and subsequent injunctive actions or administrative proceedings against offending registrants and auditors, is designed "to concentrate on particular problem areas and to anticipate emerging problems" (SEC [1989, p. 1]). The potential for SEC enforcement actions provides incentives for corporate officers and independent CPAs to avoid unacceptable practices whose "effective prosecution is

Conservatism and Auditor-Client Negotiations

Abstract: This paper examines an auditor's incentives to take actions that lead to objective financial statements. Our results challenge the common perception that auditors are conservative. Under Generally Accepted Auditing Standards, the literal claim is that financial statements are the representations of management. Our view of the auditing process, however, focuses on its negotiated character. Financial statements should be read as a joint statement from the auditor and manager. The statement becomes a joint venture if the auditor is unwilling to provide an unqualified opinion on management's stated representations. At that point, the auditor and client begin negotiations in which the auditor may offer a revised statement. The client may threaten to dismiss him and find one more accepting of its views. Or they may decide to extend the audit to obtain more facts. In the end, compromises are usually found, statements are revised, and the auditor issues an unqualified opinion on the revised statements.'

Evidence on the Possible Underweighting of Earnings-Related Information

Abstract: This study proposes and tests hypotheses related to three issues. (1) Do analysts underestimate the persistence (permanent component) of earnings forecast errors? (2) Do investors use analysts' earnings forecast revisions to reassess the persistence of previous forecast errors? (3) Do investors systematically underestimate the persistence of previous forecast errors signaled by forecast revisions? In their investigations of post-earnings-announcement drift, Rendleman, Jones, and Latan6 [1987], Bernard and Thomas [1989; 1990], and Freeman and Tse [1989] present evidence suggesting that investors systematically underestimate the persistence of earnings forecast errors. I use analysts' expectations (their forecasts) to test the hypothesis that market participants underestimate persistence (issue (1)). Freeman and Tse also show that investors reevaluate the persistence of earnings innovations in the light of subsequent earnings announcements. I investigate whether investors similarly reassess persistence in the light of subsequent analyst earnings forecast revisions (issue (2)). Finally, if investors both underestimate the persistence of forecast errors at earnings announcements and reevaluate persistence when forecasts are revised, then they may underestimate the persistence of earnings forecast errors signaled by forecast revisions. That is, investors may

Using Value Line and IBES Analyst Forecasts in Accounting Research

Abstract: This paper provides descriptive data on standard sources of analyst forecasts used in accounting research: the Value Line Investment Survey, the Institutional Brokers Estimate System (IBES), and, toa lesser extent, the Standard & Poor's Earnings Forecaster and Zacks Investment Research. We examine the relative accuracy of seven forecast error metrics, using various combinations of Value Line and IBES forecasts of quarterly earnings per share (EPS) and actual earnings as reported by Value Line, IBES, and Compustat. (Appendix A reports the relative accuracy of a forecast error metric based on a smaller sample of Standard and Poor's forecasts of annual EPS). We find the forecast error metric that pairs the Value Line forecast EPS with the Value Line actual EPS produces the smallest absolute forecast errors. We also test the association of these forecast error metrics with threeday excess returns centered on the data of a quarterly earnings announcement. The strongest associations are obtained with the use of Value Line actual earnings and either Value Line or IBES forecast data. This suggests that the choice of actual EPS data is more crucial than the source of forecast EPS data. Our overall conclusion is that Value Line

The Forecast Accuracy of Individual Analysts: Evidence of Systematic Optimism and Pessimism

Abstract: O'Brien [1990] examines the annual earnings forecast accuracy of individual analysts reporting to the Institutional Brokers Estimate System (IBES) of Lynch, Jones and Ryan during July 1975-September 1982. Using a regression model which adjusts for average firm and year effects, O'Brien finds no evidence of differential forecast accuracy. Comparing individual analysts' earnings forecasts to median consensus forecasts during 1983-86, we also find no statistically significant evidence of differential analyst forecast accuracy. Our result, however, does not mean that one analyst's forecasts are much like another's. We find that analysts are persistently optimistic or pessimistic relative to consensus forecasts. We examine this persistent behavior and its effect on measures of forecast accuracy over a sample

Trials of Legal Disputes Involving Independent Auditors: Some Empirical Evidence

Abstract: This study examines the use of trials for resolving auditor legal disputes during 1960-90. I provide evidence on the percentage of cases tried to verdict, auditor success rates at trial, judgment amounts on cases decided against auditors, post-trial appeals and settlements, and final resolutions for tried cases. I also discuss auditor reputation considerations in exercising trial options. The study suggests interpretations of observed trial rates and auditor success rates given these considerations. Trial verdicts, whether by judge or jury, are assumed to reflect the merits of cases, i.e., the correct application of the law to the events that actually occurred (Alexander [1991]). Although less than 5% of civil securities actions are litigated to verdict (Alexander [1991, p. 525]), the option of trial is thought to exist in all cases. The option is critical because it means that pretrial resolutions also tend to reflect the merits of cases.' With the option of trial, litigants rationally

The Impact of Costly Information Interpretation on Firm Disclosure Decisions

Abstract: This paper examines how investor ability or sophistication in interpreting accounting information affects firm disclosure decisions. Investor capability in acquiring and processing information is an important issue to the accounting profession in the light of accounting regulators' perceived mandate to protect small, less sophisticated investors.1 Accounting regulation, however, is not the focus of the paper. The objective is to determine whether less sophisticated investors prefer the availability of more (or better quality) information useful for trading in a securities market. Availability of information is established as the result of a managerial decision to release information about the value of a firm intended to benefit all investors. Thus, if investors benefit from trading without information, then no information is disclosed. In contrast, when information is valuable, it is made available to all investors who, limited by their resources or ability to interpret the information, independently decide how much of the information they are able to use. Both the

Empirical Analysis of Audit Uncertainty Qualifications

Abstract: This study examines the usefulness of financial statement and other data for modeling the auditor's decision process leading to the modification of audit reports for uncertainties. The auditor faces increased responsibility to evaluate and report on uncertainty about a client's continued existence under SAS No. 58 and SAS No. 59 (AICPA [1988]). A model for predicting uncertainty qualifications would be useful as an aid to this reporting decision; it could be applied early in the audit when the auditor forms an expectation of engagement risk and again at the final stage when making the reporting decision. The model could also be used as an expectations model in studies of the information content of qualified audit opinions and for investigating changes in auditors' loss functions.' In addition, a model might provide

Interindustry Differences in the Relation between Compensation and Firm Performance Variables

Abstract: In this study I document interindustry differences in the relation between CEO compensation and accounting-based firm performance variables under the assumption that firms in the same industry face similar production environments. If CEO compensation is related to firm performance because the latter reflects executive performance,' differences in production environment should cause interfirm differences in the relation between CEO compensation and accounting-based firm performance. I focus on this relation because one objective of accounting-the stewardship objective-is to provide information useful in evaluating managers. I examine four kinds of variables which reflect executive performance, taken from discussions by Standard & Poor's industry analysts: stock returns, accounting returns, sales revenue, and net interest income. These variables are examined for banks, electric utilities, oil and gas firms, and retail groceries between 1978 and 1982. The analysis examines both the explicit contracts made public by firms and the implicit statistical relation between compensation and firm performance.

Time-Varying Stock Price Response to Earnings Induced by Uncertainty about the Time-Series Process of Earnings

Abstract: In this paper, I examine how changes in the level of uncertainty about the time-series process of earnings affect the magnitude of the stock price response to earnings announcements. The basic premise is that when there is more uncertainty about the time-series parameters of earnings,' a given level of unexpected earnings can have a larger effect on stock price because it is weighted more heavily by investors in determining the value of the firm. Tests are based on a simple model in which price is a function of expected future earnings which follow a random walk with drift time-

Public Signals and the Equilibrium Allocation of Private Information

Abstract: The purpose of this paper is to examine how accounting disclosures can affect the equilibrium allocation of private information. In addition to various kinds of publicly available information, such as accounting disclosures, an investor can also acquire private information for a cost. In such an environment, changes in accounting disclosure requirements may change investors' incentives to acquire private information, so part of the impact of a new accounting disclosure requirement may well be changes in the acquisition of private information. In an economy with informative prices, however, the allocation of private information must be determined as part of an overall equilibrium. As traders choose between signals from different information sources they rationally anticipate the information that will be freely available by observing the asset's price. But the informativensss of price depends on the allocation of private information. Thus an equilibrium model of the information environment must be used to assess the effect of different disclosure requirements. I consider an economy with two different sources of private information. Each trader may remain privately uninformed, or purchase a signal from only one information source, or purchase a signal from both infor-

The Information Content of Earnings, Revenues, and Expenses

Abstract: In this paper we model risk-adjusted returns at earnings announcements as a function of unexpected revenues and unexpected expenses, in order to test for the information content of the components of earnings as well as for their incremental information content over earnings. We use Value Line (VL) forecasts of earnings and revenues as a proxy for the market's expectation of these numbers and as a basis for the market's expectation of expenses. We find both revenues and expenses have information content that is incremental to earnings. We also model riskadjusted returns as a function of earnings and revenues to compare our findings with previous research that used a martingale model to derive expected revenues. Consistent with previous research, we find no incremental information content in revenues in this formulation. However, we find information content in both earnings and revenues when expectations are taken from VL forecasts. Wilson [1986] found that investors used the earnings and revenues released at the preliminary announcement date to forecast the accruals and funds subsequently disclosed in the annual report or 10-K. However, he found no evidence of information content for revenues at this date. Wilson used prior periods' revenues, cash from operations, current and noncurrent accruals, and capital expenditures to predict revenues. Using

Collusion in Auditing

Abstract: This paper is concerned with the effects of collusion between agents in a principal-agent model of auditing. By collusion we mean private, extralegal arrangements in which agents agree to act in ways not intended by the owner.1 The effects of collusion can extend beyond cases when it is detected and prosecuted, because the potential for collusion may cause the owner to modify the agents' contracts or the firm's operating policies and accounting procedures. These actions by the owner may, in turn, distort economic activity relative to an environment with no potential for collusion. Such repercussions can be especially serious in auditing. Because auditing arose to overcome informational asymmetries between owners of resources and managers who acted on their behalf, its value depends crucially on whether the manager and the auditor collude. Owners can

Participation, Slack, and Budget-Based Performance Evaluation

Abstract: In this paper we discuss a class of budget-based performance evaluation schemes with the desirable feature that they induce an informed manager to set unbiased standards. We show that these schemes are frequently optimal incentive contracts in the presence of moral hazard, and we find that they retain their incentive properties in the presence of several competing managers. For concreteness, our analysis focuses on the problem faced by headquarters (HQ) in evaluating the performance of a cost center manager. In the simplest form of the budget-based schemes, compensation can be expressed as the sum of two terms. The first depends only on a cost estimate (standard) issued by the manager and the second term consists of the difference between estimated and actual cost, multiplied by a proportionality factor which varies with the estimated cost. A budgetbased compensation scheme can then be viewed as a menu of linear compensation functions, each corresponding to a different cost estimate submitted by the manager. In previous work, Ijiri, Kinard, and Putney [1968] discuss an evaluation system based on estimated and actual performance. However, they do not explicitly model preferences, information asymmetries, or moral hazard, and therefore they cannot model the behavior induced by their proposed evaluation scheme or compare alternative evaluation schemes. In reference to a proposed Soviet incentive scheme, Weitzman [1976]

Public Disclosure and the Structure of Private Information Markets

Abstract: This study investigates the relationship between private information markets and the disclosure policies of publicly traded firms.1 The main point of the paper is that the structure of private information markets is crucial in determining investor demand for information disclosures. The value of public disclosure to traders is shown to vary dramatically with the structure of the private information market. It is also demonstrated that if firms are given the power to alter the structure of the private information market through selective private disclosures of information before any public release, traders may be made better off. These results are consistent with empirical observations regarding the public release of management earnings forecasts. It is observed that firms may privately inform securities analysts of earnings forecasts before public release (if any), apparently influencing the structure of the private information market. In the mid 1970s, the SEC, in response to this practice, attempted to mandate forecast disclosures. But this SEC action was strongly op-

A Meta-Analysis of Studies on Internal Control Judgments

Abstract: The level of consensus among auditors in evaluating internal control quality and determining the level of substantive testing required has been studied more than any other topic in audit decision making (Ashton [1983] and Libby, Artman, and Willingham [1985]). Most studies in this area have replicated or extended the work of Ashton [1974] and Joyce [1976] with the purpose of testing the generalizability of the Ashton study or reconciling Ashton's finding of high mean consensus for internal control evaluations with Joyce's finding of low mean consensus for audithour estimates. Earlier literature reviews in this area concluded that while there was reasonable consensus among auditors on evaluation of internal control, there was little consensus with respect to the planning of substantive tests (for example, Joyce and Libby [1982] and Ashton [1982]). However, with the benefit of subsequent work by Gaumnitz et al. [1982] and Kaplan [1985], recent reviews suggest that "the results are still very tentative" (Felix and Niles [1988]). The apparent conflict between different studies has been accompanied by continued calls for further research (Kaplan [1985]). The purpose of this paper is to use meta-analysis to examine the possibility that the apparently conflicting findings across internal control judgment studies are purely artifactual. Meta-analysis quantitatively

The Impact of MAS on Auditors' Independence: An Experimental Markets Study

Abstract: In this paper we report results from an experimental markets study of how the provision of a management advisory service (MAS) and an audit service might affect the demand for and the supply of these interrelated services. This study was originally motivated by the long-standing debate on whether the provision of MAS adversely affects auditor's independence. As the study progressed, however, the complex interactions between MAS and auditing services led us to broaden our focus to include other potential effects of allowing auditors jointly to provide both services. These other effects can confound the study of the independence issue, as we note below. In its early stages, the debate on the independence issue focused on whether the provision of MAS that was an integral part of the audit (e.g., design of clients' information and internal control systems) would prevent auditors from objectively reviewing the quality of these services (Metcalf Committee Staff Study [1977]). The Cohen Commission [1978], organized by the AICPA to investigate allegations of audit inadequacies, concluded that it could not find evidence indicating that the provision of MAS was associated with substand-

Timely Aggregate Analyst Forecasts As Better Proxies for Market Earnings Expectations

Abstract: Previous research (e.g., O'Brien [1988], Stickel [1990], and Brown [1991]) has documented that timely composites of analysts' forecasts are superior to the mean forecast in terms of predictive ability. An alternative criterion in choosing an earnings expectation proxy is market association, whereby the forecast whose error is most highly correlated with abnormal returns is the proxy of choice (Foster [1977]). This paper shows that timely composites are superior to the mean on the market association dimension. The results are robust to the three timely composites considered by Brown [1991] and pertain to each of five years and two deflators.

Stock Price Behavior Associated with Managers' Earnings and Revenue Forecasts

Abstract: Managers' earnings forecasts are associated with statistically significant stock price reactions. While nearly half of all earnings forecasts are released with revenue forecasts, the motivation for and the effects associated with revenue forecasts are unknown. This paper proposes and tests hypotheses involving the stock price informativeness of both earnings and revenue forecasts. The "expectations adjustment" hypothesis advanced by Ajinkya and Gift [1984], and generalized by King, Pownall, and Waymire [1990], predicts that managers release forecasts to align equilibrium prices of common stocks with those of managers. Under this view, both earnings and revenue forecasts are mechanisms by which managers adjust expectations. Since releasing forecasts entails costs, revenue forecasts will accompany earnings forecasts when the latter are insufficient to adjust stock prices consistent with managers' expectations. This yields our paper's primary hypotheses: (1) earnings forecasts released without revenue forecasts are more price informative, and (2) revenue forecasts are price informative. Since the magnitude and opportunities for trading gains from foreknowledge of information is greater for large firms, we

Contracting Frictions, Regulation, and the Structure of CPA Firms

Abstract: The prominence of management consulting services in the largest CPA firms leaves little doubt that there are economies of scope between auditing and at least some types of consulting. The source of these economies of scope has been conjectured to be the result of information produced as a by-product of performing audit work (e.g., Simunic [1984]). This information may be about the benefits to a client from a certain type of consulting project, or it may be about how best to produce desired consulting services and thereby reduce the cost of supplying these services. The purpose of this paper is to explore theoretically another potential source of economies of scope: contracting frictions. The particular contracting frictions we study arise from the CPA firm's private information about the costs of performing auditing and consulting for a particular client. We show such private information may give rise to economies of scope, in the sense that the client is better off purchasing auditing and consulting from the same CPA firm as opposed to separate sourcing of the two

Loss Contingency Reports and Stock Prices: A Replication and Extension of Banks and Kinney

Abstract: In this study I replicate and extend Banks and Kinney's [1982] investigation of loss contingency reports and stock prices by examining 72 firms that experienced new loss contingencies during 1976-84. Banks and Kinney's sample consists of 92 new loss contingency firms and covers 1969-75. Sample firms in both studies are located by inspecting the "Loss Contingencies" section of Accounting Trends and Techniques (AICPA [1976-85]) and include 28 firms that received new qualified opinions during 1969-84. I extend the original analysis by examining the influence of several factors on auditors' decisions about the seriousness of new loss contingencies. These factors include client size, general macroeconomic climate, and unexpected earnings. I test Banks and Kinney's hypotheses by using a combined (and therefore larger) sample, and I present evidence from a different time period. Conditions external to the firm such as the general economic climate are expected to affect experimental conditions, and possibly the conclusions, of Banks and Kinney's study. My results generally support Banks and Kinney's findings. Most important, loss contingency firms in

Voluntary Disclosures When Seller's Level of Information Is Unknown

Abstract: In this paper we report the results of experimental markets designed to test a disclosure model based on the models of Dye [1985] and Jung and Kwon [1988]. These authors show that when receivers of information do not know whether senders possess private information, the senders will not fully disclose their private information. Their models were motivated by the discrepancy between the theoretical predictions for voluntary disclosures and empirical results. In the theoretical area, Grossman [1981] and Milgrom [1981] predicted that private information will be fully disclosed when disclosures are credible and receivers know the holder has private information; agents disclose to identify themselves as not possessing the worst possible information. Watts [1977] argued that voluntary disclosure will occur because of market pressures and the threat of regulatory intervention. Beaver [1977; 1988] described how auditing and legal liability may induce full disclosure. Nevertheless, empirical research indicates full disclosure is not always observed (e.g., Penman [1980] and Seligman [1986]).

Ranking of Accounting Information Systems for Management Control

Abstract: Analysis of the stewardship role of accounting information involves both choosing an accounting system and designing a compensation contract under the chosen system. Accounting issues related to the first of these include the choice between cash and accrual accounting methods and direct versus absorption costing. A given accounting system yields an income number according to its valuation process where accounting income could be viewed as an estimator of some unknown variable such as management performance. Taking this perspective, the choice of accounting methods could be interpreted, ceteris paribus, as an attempt to enhance the accuracy of accounting earnings as estimators of management performance. In this paper, our objective is to provide a simple criterion to determine the value of the accounting information system for management control. The choice of accounting information system has been a fundamental issue in accounting research. Feltham [1968] introduced a formalized approach based on information economics for measuring the value of changes in a management accounting system. Earlier research basically applied Blackwell's theorem to obtain the result that costless accounting information systems can be ranked by and only by the fineness criterion in a single-person setting. Results on the value of an information system in a principal-agent framework are found in Holmstrom [1979; 1982],

An Independent Auditor's Ex Post Criteria for the Disclosure of Information

Abstract: The auditing profession considers materiality to be a fundamental determinant of disclosure decisions. There are two types of materiality: discovery materiality is a planning concept applied to expected errors and omissions, whereas disclosure materiality refers to errors and omissions which come to the auditor's attention during the course of the audit.1 Disclosure materiality creates a class of detected items which do not require disclosure because they are deemed immaterial. This seems curious: why isn't more disclosure preferred to less?2 Previous papers about disclosure have assumed that the auditor's profit orientation affects the auditor's opinions and may compromise independence. That is, the desire to maintain long-term client relations or generate profitable MAS engagements may sway the audi-

Discussion of The Financial and Market Effects of the SEC Accounting and Auditing Enforcement Releases

Abstract: The paper under discussion explores the Securities and Exchange Commission's enforcement function related to the issuance of Accounting and Auditing Enforcement Releases (AAERs). It encompasses a rich description of the nature of the problems resulting in AAERs, the resulting sanctions against the companies and their auditors, and the market reactions to the disclosures associated with the SEC enforcement actions. The paper contributes to the accounting literature by providing a thorough description of SEC enforcement cases related to accounting and auditing issues. One appendix summarizes 58 AAERs about the companies used in the market tests. This discussion combines issues we found to be important as well as areas discussed by conference participants. We organize our discussion into the following areas: the paper's motivation, information disclosure issues, empirical tests, and the paper's conclusions. 2. Motivation The authors motivate the paper as a descriptive analysis of the SEC's use of AAERs in its enforcement program. Conference participants indicated some confusion about the SEC's purposes in issuing AAERs. The paper stresses an AAER's importance for anticipating emerging reporting issues; we believe that this motivation has been overemphasized.