Knowledge that Transforms

Differences in property rights create a motive for trade among otherwise identical regions. Two regions with identical technologies, endowments, and preferences will trade if one, the South, has ill-defined property rights on environmental resources. Trade with a region with well-defined property rights transmits and enlarges the problem of the commons: the North overconsumes underpriced resource-intensive products imported from the South. This occurs even though trade equalizes all prices, of goods and factors, worldwide. Taxing the use of resources in the South is unreliable as it can lead to more overextraction. Property-rights policies may be more effective.

[Accounting numbers are frequently used in evaluating management performance, and performance evaluation is an important ingredient in motivating managers. Three significant factors generally create difficulties in developing performance measures for a given manager. First, the actions and strategies implemented by the manager are not observable directly, so the manager cannot be compensated directly for his input into the firm. Second, the full consequences of the manager's actions are not observable, in large part because the impact of those actions extend beyond his subunit of the firm and beyond his time as manager of that subunit. Third, uncontrollable events influence the consequences that are observed. The agency theory literature has explored extensively the implications of the nonobservability of the manager's actions and the fact that performance measures are influenced by unobservable, uncontrollable events. However, this literature has given only limited attention to the fact that performance measures frequently are incomplete or imperfect representations of the economic consequences of the manager's actions.1 On the other hand, discussions of performance evaluation in management accounting texts often raise issues regarding the incompleteness and imperfectness of the accounting numbers that are used as performance measures. For example, divisional accounting profit is described as a short-term financial measure that may induce managers to ignore the future economic consequences of their current actions.2 More generally, management accounting texts discuss various problems that arise in inducing managers to have goals that are congruent with those of the firm's owners.3 These discussions typically follow one of two tacks. First, most texts discuss alternative methods for measuring various accounting numbers. For example, discussions of divisional profit measures often consider direct costing versus absorption costing, the elimination of allocated fixed costs, market versus cost based transfer prices, and the inclusion of interest charges for assets used. The objective here is to create a single measure that is as congruent with the firm's objectives as possible. Second, some texts discuss the use of additional, often nonfinancial, performance measures. Kaplan and Atkinson (1989, 536) refer to General Electric and McDonald's as leaders in the use of such measures, and Anthony et al. (1992, 651) provide the following summary of their measures. McDonald's evaluated its store managers on product quality, service, cleanliness, sales volume, personnel training, and cost control. When General Electric decentralized in the 1950s, it identified multiple measures of divisional performance: profitability, market position, productivity, product leadership, personnel development, employee attitudes, and public responsibility. This paper uses an agency theory model to explore the economic impact of variations in performance measure congruence and the use of multiple performance measures to deal with both problems of goal congruence and the impact of uncontrollable events on performance measures. To address the congruency issues, we use a multidimensional representation of the manager's actions. Most of the agency theory literature has examined models in which the manager's action space is either single dimensional or finite. Our approach is similar to the multi-task model examined by Holmstrom and Milgrom [HM] (1991). Our analysis differs from theirs in that we focus on performance measure issues and consider measures that may be influenced by more than one element of the manager's action. The key characteristics of a single performance measure are its congruence with the principal's expected gross payoff and its noisiness (due to uncontrollable events). The first-best result is achieved if, and only if, the performance measure is perfectly congruent and noiseless. A contract based on a noncongruent measure induces suboptimal effort allocation across tasks, whereas performance measure noise results in suboptimal effort intensity. We characterize the value of providing additional performance measures, and illustrate the use of additional measures to reduce risk and noncongruity (due to myopia and window dressing). The value of an additional measure is zero if, and only if, the existing measures constitute a sufficient statistic for the additional measure with respect to the manager's action. The terminal value of the firm is not contractible information if it is realized subsequent to the contract termination date. However, the market price (at the contract termination date) of a publicly traded firm is contractible information. The analysis demonstrates that while price efficiently aggregates investor information for valuation purposes, it is not likely to be an efficient aggregation for incentive purposes. Hence, there is a loss of efficiency if the price is used as the sole performance measure. Of course, it can be a valuable performance measure if it contains otherwise noncontractible information.]

[Litigation risk is a significant and increasing concern for U.S. public accounting firms. Ernst & Young's recent 400 million settlement with the FDIC is an indication of the magnitude of the problem facing the Profession. A recent survey conducted by the AICPA shows that malpractice insurance premiums for CPA firms other than "Big 6" have increased 300 percent since 1985, while deductibles have increased almost six times. Forty percent of those firms surveyed are "going bare" due to the high cost of liability insurance. extasciicircum\1\ In addition, partners from Laventhol & Horwath, previously the seventh largest accounting firm in the U.S., cited litigation claims against their firm in their decision to declare bankruptcy, and Palmrose (1988) notes that litigation against an audit firm can impair its reputation by providing a negative signal about the quality of the firm's audit services. In an effort to combat the increasingly litigious business environment, the "Big 6" recently issued a Statement of Position which has been distributed to audit clients, accounting faculty, state and federal legislatures, and members of selected government organizations. extasciicircum\2$ In such an environment, it is important that auditors be able to effectively screen potential clients and accurately assess litigation risks. Indeed, many accounting firms already appear to be more carefully screening new clients and rejecting some who, prior to the litigation explosion, would have been accepted. The purpose of this study is to examine this screening process, and to determine whether auditor judgments of litigation risk and their recommendations for the preliminary audit plan and client fees are influenced by certain client characteristics that have been empirically related to audit litigation in the accounting literature. Specifically, we hypothesize that client financial condition, asset structure (proportion of receivables and inventory to total assets), sales growth, market value of equity, and variability in stock price returns relate to auditor judgments of litigation risk, to their recommendations for the amount of evidence required to reduce the risk of a material misstatement to an acceptable level, and to client fees. The hypotheses are tested in a field experiment where 243 audit partners and managers of four "Big 6" firms from offices throughout the U.S. were each asked to review a single case describing a prospective audit client, and then (1) assess certain elements of litigation risk associated with the engagement, (2) evaluate the financial condition of the client, and make recommendations for (3) the required amount of audit evidence and (4) client fees. Asset structure, sales growth, firm market value, and stock return variability were each assigned two levels (high/median) in the between-subjects experimental design, giving rise to 16 versions of the case which were distributed randomly across the subject sample. The results indicate that the client's overall financial condition is the primary consideration in the auditor's assessment of litigation risk and recommendations for the audit plan and fees. Poorer financial condition was associated with higher levels of litigation risk, more audit evidence, and higher audit fees. The results for asset structure (receivables and inventory as a percentage of total assets) were generally consistent with the hypotheses and with the results for financial condition, though much weaker. Client market value and sales growth were generally unrelated to litigation risk, and the variability of the client's stock price was either ignored or viewed as relating negatively to litigation risk. Additional tests suggest that audit fees reflect both the amount of audit evidence collected and an additional premium to cover litigation risks. That is, auditor assessments of a client's overall litigation risk explained a significant amount of the variance in audit fees over and above the amount explained by audit evidence, suggesting that auditors may be charging clients to insure against future litigation losses. The evidence does suggest, however, that the portion of the audit fee constituting the insurance premium is unrelated to the client characteristics examined in this study. Identifying the client characteristics that relate to the insurance premium may be an important area for future research. In the next section, prior research is reviewed and its relationship to the design of the reported study is explained, followed by descriptions of the theoretical model and related hypotheses. The data collection and analysis procedures are then described, and the paper closes with a discussion of the results and implications.]

[The objective of this study is to examine the effect of the default risk of debt on the relation between accounting earnings and stock returns. Recent research suggests that measurements of equity beta do not capture all dimensions of riskiness of equity. The default risk of debt may help explain how accounting earnings are linked to stock returns because the default risk of debt may capture some elements of riskiness of equity that are not captured by equity beta. We document empirically that the coefficient relating unexpected changes in earnings to abnormal stock returns (the earnings response coefficient or ERC) is negatively related to the default risk of debt as measured by bond ratings.]

[This article considers errors in databases commonly used by researchers. Specifically, the study investigates the manner in which the Center for Research in Security Prices (CRSP) tapes adjusts prices for stock distributions, i.e., stock dividends and stock splits. All distributions reported by CRSP during the period January 1 through December 31, 1989 were reviewed for proper distribution code, record date, ex-dividend date, and distribution date by comparison to a secondary data source, Moody's Dividend Record (MDR). Additionally, the accuracy of the factor used by CRSP to adjust the price and number of shares outstanding for the stock distribution was verified by comparison to MDR. Completeness of CRSP reporting was tested by tracing all stock distributions reported by MDR back into the CRSP tapes. In all, 718 distributions were examined. All differences (142, or 20 percent of the distributions) were reconciled where possible (11 could not be resolved) by examination of the respective companies' annual reports. Coding differences (91, or 64 percent of the differences) arose because of CRSP policy of designating as stock dividends all distributions that are less than or equal to 20 percent of the then-existing shares while all others are stock splits. This coding policy may affect research that uses stock distributions to test signalling by management. The remaining 51 exceptions (36 percent) included 20 ex-date differences that were perceived to be of little consequence, and 31 dissimilarities (22 percent) that are considered significant. In 27 of these variances, CRSP was found to be in error, which ranged from 75 percent to 100 percent when compared to primary data sources. In a second phase, the 1990 CRSP tape was examined to follow-up the status of 44 errors observed in the data review of previous work by these authors utilizing 1981 and 1982 data and of errors detected in phase one of this study. The evidence demonstrates that some errors remain undetected for long periods of time. Finally, the degree to which errors may affect the statistical testing of volume variables showed no significant bias.]

[This article examines whether reported accounting earnings reflect benefits from past research and development (R&D) expenditures and uses the benefits, if any, to estimate the investment value of R&D. The issue is how to extract realized R&D benefits from income statement numbers and is important given the current accounting policy of expensing R&D as incurred. To the extent that market participants can determine realized benefits and expect these benefits to persist in the future, they will use accounting earnings numbers to value current R&D. This study uses cross-sectional data to estimate a recursive system of two equations: one for earnings and one for valuation. The earnings equation associates earnings with recorded assets, advertising, and R&D expenditures. It extracts realized R&D benefits from reported earnings numbers. The valuation equation relates market values of equity to book values, earnings, and R&D expenditures. It determines how the accounting and R&D numbers are valued in the market. The coefficients derived from these two equations are then used to estimate the investment value of R&D. This system of equations assumes that past R&D generates earnings that create market value. The results from the earnings model indicate that reported earnings, adjusted for the expensing of R&D, do reflect realized benefits from R&D. On average, a one-dollar increase in R&D expenditures leads to a two-dollar increase in profit over a seven-year period. The results from the valuation model indicate that investors place a high value on R&D investments. On average, a one-dollar increase in R&D expenditure produces a five-dollar increase in market value. This effect of R&D on market values can be separated into an indirect and a direct component. The indirect effect, when R&D outlays affect market values through earnings, is the capitalized value of R&D benefits reflected in earnings and expected to persist, given that R&D is continuous. In contrast, the direct effect reflects new R&D information conveyed directly by R&D variables. On average, the indirect effect is much larger than the direct effect, implying that R&D information conveyed by earnings numbers is more valued than the information conveyed by the R&D variables themselves. Finally, the study controls for the valuation of R&D tax shields generated when firms expense R&D for tax purposes, and/or qualify for the R&D tax credit. The tax shields are found to be relevant and are valued as earnings.]

[This study investigates how disclosed fair value estimates of banks' investment securities and securities gains and losses based on those estimates are reflected in share prices in comparison with historical costs. Fair value securities gains and losses are calculable because banks also disclose realized securities gains and losses. Thus, banks' investment securities provide an opportunity to examine two measurement methods, historical cost and fair value, for both an asset and its related earnings component. Previous research does not provide strong evidence on value-relevance of asset fair value estimates. Errors in estimating the fair values is the primary explanation for this unexpected finding. Another explanation relates to cross-sectional differences in sample firms, e.g., industry membership. This study examines disclosed fair values of investment securities that can be considered more reliable than previously-studied fair value disclosures. Moreover, the sample firms here belong to one industry, banking. This study also investigates the Barth et al. (1990) suggestion that fair value securities gains and losses are value-relevant. By examining how share prices reflect historical costs and fair values, evidence is provided on the measures' relevance and reliability. Because these are the FASB's two principal criteria for choosing among accounting alternatives [Statement of Financial Accounting Concepts (SFAC) No. 2, FASB 1980], the evidence can inform the FASB's deliberations on using fair value accounting for investment securities, to the extent the disclosed fair value estimates would be used to measure investment securities under fair value accounting. Share prices for a sample of banks are explained using investment securities historical costs and fair value estimates together with the book value of equity before investment securities. Similarly, bank stock returns are explained using securities gains and losses based on historical costs and on fair values together with earnings before securities gains and losses. The analyses provide evidence on the two methods' incremental and relative explanatory power, and relative measurement error. The findings indicate that fair value estimates of investment securities provide significant explanatory power beyond that provided by historical costs. Strikingly, historical costs provide no significant explanatory power incremental to fair values. Using a measurement error model, investment securities' fair values are found to have less measurement error than historical costs vis-a-vis the amount reflected in share prices. The findings for securities gains and losses are different. The significance of any incremental explanatory power for fair values beyond historical costs depends on the specification of the estimating equation. In some specifications, fair value securities gains and losses have no significant incremental explanatory power, but historical costs always provide explanatory power incremental to fair values. The findings based on a measurement error model indicate that fair value securities gains and losses also have more measurement error than historical costs. Thus, although fair value estimates of investment securities appear reliable and relevant to investors in valuing bank equity, fair value securities gains and losses do not. One interpretation for these findings is that although estimation error in the disclosed fair values is small enough that investment securities' fair values appear value-relevant, when two annual fair value estimates are used to calculate securities gains and losses, the effect of the combined estimation errors renders securities gains and losses value-irrelevant. Another plausible interpretation is that securities gains and losses might be offset by unrecognized correlated gains and losses on other assets and liabilities. Why this affects securities gains and losses but not investment securities is an unresolved question. Evidence from supplemental analyses gives more credence to the first interpretation than to the second.]

[The Value Line Investment Survey has recently expanded its database of financial information on public firms from approximately 1,600 to over 4,000 companies to be more competitive in the financial database market. In addition, recent research (Philbrick and Ricks 1991) has shown that in determining earnings surprise, Value Line is a better source for actual EPS data. Since most research has been based on samples drawn from the COMPUSTAT database, increasing attention to the Value Line database leads one to question the effects of database choice on empirical research. One purpose of this study is to examine the differences in financial data between COMPUSTAT and Value Line along with the differences in the distribution of the size of firms between the two databases. Significant differences are found between COMPU-STAT and Value Line in the types of financial data reported for commonly used data items such as sales and total assets. In addition, the distribution of the size of firms in the databases has shifted over time. Prior to 1985 the bottom three quartiles of firms were significantly larger in Value Line. Beginning in 1985 the COMPUSTAT database had significantly larger firms across all quartiles. A second purpose is to demonstrate how the differences in the two databases can materially affect inferences about the population of firms. A study analyzing effective tax rates provides a good example because the use of the different databases produces very different results. This study extends prior research by examining which differences in the databases generate these different results. Much of the difference in the results is attributable to the different firms in the two databases. However, after controlling for common firms, the remaining significant differences can only be attributed to differences in the manner in which the financial accounting data are assimilated into the databases.]

[Regulatory bodies that oversee the provision of audit services have recently expressed concern about the common practice of pricing initial audits significantly below cost (lowballing). Specifically, it is feared that lowballing could weaken auditor independence and reduce audit quality, since lowballing could provide clients with a credible threat of terminating incumbent auditors should they refuse accounting concessions. However, Magee and Tseng (1990) have shown that when auditors possess all bargaining power and there is no disagreement among auditors on the proper interpretation of GAAP, clients have nothing to gain by threatening termination of incumbent auditors and there is no weakening of auditor independence. Therefore, the concern expressed by regulators must presuppose that clients (i) possess bargaining power superior to that of auditors, and (ii) are free to change auditors at any time. But, if these features are true, it is puzzling why lowballing would occur in the first place. Lowballing can only occur if there are rents to be earned by auditors (DeAngelo 1981a), but such rents seem to be inconsistent with clients possessing most of the bargaining power (Dye 1991; Magee and Tseng 1990). We construct and analyze an economic model of audit pricing which shows how equilibrium audit prices would sustain rents and lowballing even when clients have most or all of the bargaining power and are free to change auditors every period. Our analysis also throws light on the related phenomenon of auditor turnover, and shows that the efficient pricing of audit services by itself precipitates some turnover apart from any turnover due to other forces such as client-auditor disagreements (Dye 1991) and client-auditor matching (Gigler and Penno 1993). Given auditor turnover, we analyze how audit prices, lowballing, and turnover rates evolve over time.]