Knowledge that Transforms

[This paper demonstrates how a manager's concern for reputation can distort reports made to superiors about an investment project and hence, can affect a firm's capital budgeting decisions. In the first setting examined, a manager is assumed to know more than her superior about both her personal abilities and the prospects of a project under consideration. A manager's ability has two dimensions-ability to forecast a project's returns and productivity. A more talented manager has both better forecasting abilities and higher productivity than a less talented manager. It is shown that while a more talented manager always reports her assessment of a firm's project truthfully, a less talented manager's report depends on the magnitude of the difference in productivities between the more and less talented managers. When this productivity gap is large, the less talented manager conceals her lack of talent by claiming that the project's returns are low so as to discourage investment by the firm. Shifting blame to factors beyond her control protects the manager's reputation. Such managerial misreporting results in underinvestment by the firm. In contrast, where the productivity gap between a less talented manager and a more talented manager is small, a less talented manager guards her reputation by sometimes reporting favorable prospects and sometimes unfavorable prospects. This leads the firm either to over- or underinvest its resources, respectively. Thus, managerial misreporting occurs in equilibrium because a less talented manager tries to masquerade as a more talented manager, resulting in investment distortions. Whether a manager's concern for reputation exacerbates or mitigates the incentive problem depends on the manager's type. While the labor market forces align the incentives of a more talented manager with those of the firm, they also serve to misalign incentives for a less talented manager. In the second setting, this paper examines managerial investment distortion in the choice between short term and long term projects. Consider a scenario in which the outcome of a short term project is observed publicly earlier than that of a long term project. It is shown that managerial reputation incentives, coupled with superior two-dimensional private information, would cause a more talented manager to implement a short term or a long term project as dictated by the firm's interests, whereas a less talented manager with low productivity would choose a long term project. Through such choice, she is able to delay disseminating project outcome which is also informative about her type. A less talented manager who is relatively more productive would, however, implement a short term project sometimes and a long term project some other times. These investment distortions cannot be avoided either by restructuring the decision-making responsibilities or by the principal's committing to any implementation rules.]

[This study investigates the impact of the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (FASB 1990, hereinafter, SFAS 106) for a sample of rate-regulated public utility firms. The results of a recent study by Espahbodi et al. (1991) of the market reaction to the issuance of the exposure draft for SFAS 106 suggest that, for a sample including both regulated and non-regulated firms, investors perceived the required disclosures as value-decreasing due to higher contracting costs. However, the unique institutional setting for rate-regulated firms implies that while a similar negative market reaction may result for some regulated firms, there is also a theoretical basis for predicting either no market reaction or a positive reaction to the proposed accounting standard. The no reaction hypothesis is motivated by the nature of the relationship between regulatory rate-setting process and special external financial reporting procedures; as a result, some regulated firms may be sheltered from the indirect costs attributed to SFAS 106. A prediction of a positive market reaction arises from the notion that accounting rules can have an effect on the way regulators set rates, resulting in a direct (positive) cash flow effect for some of the sample firms. Our results suggest that investors in public utilities did not, on average, view the proposed standard as a value-decreasing event. This result is in sharp contrast to the Espahbodi et al. (1991) finding of a large negative average reaction for firms affected by SFAS 106. We also find evidence that the market reaction at the exposure draft announcement varies cross-sectionally based on the market's exante expectation of regulators' actions and the resulting changes in revenues from the adoption (or non-adoption) of the accounting rule for ratemaking purposes. The results thus add to a growing body of literature which demonstrates differences in the market's assessment of accounting information across regulated and non-regulated industries. More importantly, the results point to the role of regulatory response in the market's assessment of impending accounting changes in regulated industries.]

[Accounting numbers are an integral part of the firm's formal and informal contracts (Watts 1974; Holthausen and Leftwich 1983; Watts and Zimmerman 1986; Ball 1989; Christie 1990). This contracting-based theory of accounting is based on the premise that managers choose particular accounting procedures either efficiently to maximize the value of the firm, or opportunistically to make the manager better off at the expense of some other contracting party (Holthausen 1990). The relative amounts of efficiency and opportunism depend on controls on managers' accounting discretion. Such controls include monitoring by the board of directors, competition from the product markets and from within the firm by other managers, and the discipline of the market for corporate control. It is difficult to determine whether managers make accounting choices to maximize firm-value. Empirical tests often assume opportunism and usually reject the null hypothesis of no association between accounting choice and firm-specific variables such as leverage (Christie 1990). However, many of the empirical regularities interpreted as evidence of opportunism can also be interpreted as occurring for efficiency reasons, which serves to confound these findings (Watts and Zimmerman 1986; Watts and Zimmerman 1990; Sweeney 1994). The few tests based on efficiency rationales find an association between the contracting variables and accounting choice (Zimmer 1986; Whittred 1987; Malmquist 1990; Mian and Smith 1990a). This paper measures the relative influences of efficiency and opportunism in accounting choice by examining a non-random sample that maximizes the probability of finding opportunism. Economics and finance studies document that corporate control actions such as tender offers and proxy fights discipline opportunistic managers. Therefore, we select a sample of takeover targets and examine this sample for evidence of managerial opportunism in choice of accounting procedures. A key assumption of our tests is that, prior to the control action, corporate control targets contain more non-value-maximizing managers than surviving firms in the same industry that were not targets of corporate control actions. This assumption allows us to use surviving firms' accounting procedures as the benchmark for the efficient accounting choice. In this application of Alchian's (1950) "economic Darwinism," surviving firms on average are more efficient than non-surviving firms. An unbiased estimate of accounting opportunism in this sample is an estimate of the upper bound on the amount of accounting opportunism in a random sample of firms. If there is little or no opportunism in our non-random sample, then for firms generally we can discount opportunism as an explanation for choice of the three accounting methods we study. Efforts to explain choice of accounting methods could then be redirected towards efficiency explanations. We measure opportunism by comparing the frequency of choice of income-increasing procedures by takeover targets with the corresponding frequency of their surviving industry peers. We find that takeover targets select income-increasing depreciation, inventory, and investment tax credit (ITC) accounting methods more frequently than their surviving industry peers in up to 11 years preceding the control action. Our analysis includes a multiple regression that controls for efficient choice of accounting methods. Our estimate of the upper bound on the frequency of opportunism is small relative to the mean choices of surviving firms. We conclude that some accounting opportunism exists in the takeover targets, but that efficiency is the more important explanation of accounting choice. However, while the frequency of opportunism is relatively small, the dollar effect on retained earnings of selecting an income-increasing method is large. For the median target firm, the after-tax effect on retained earnings if the firm had been on the alternative method is about 26 percent for depreciation, 9 percent for inventory, and around 5 percent for the ITC.]

[As examined in previous research (e.g., Gramlich 1991; Dhaliwal and Wang 1992), accounting accruals related to the alternative minimum tax (AMT) may either contain effects unrelated to the book income adjustment or be confounded by other changes in the 1986 Tax Reform Act. For example, total accruals in Gramlich (1991) arising from changes in accounts receivable and inventory have no effect on the book income adjustment because they affect taxable income and book income simultaneously.1 Also, the repeal of the investment tax credit and a slower capital recovery schedule in the 1986 Tax Reform Act may induce firms to reduce investment. This change may decrease depreciation (a component of accruals in Gramlich (1991)) and the depreciation timing difference (a component of accruals in Dhaliwal and Wang (1992)) in 1987 and may contribute to the observed results.2 Prior research also relied on pre-1987 data and certain assumptions to predict the likelihood that firms would be subject to the AMT in 1987 (see Gramlich (1991) and Dhaliwal and Wang (1992) for examples). Such an approach is warranted only under an assumption of no change in tax status for the sample firms. However, the overwhelming changes instituted by the 1986 Tax Reform Act make such an assumption questionable. Misclassification of firms can lead to results attributable to sample partition rather than the AMT. Furthermore, firms with low tax payments are classified as the AMT firms in these studies. Since low tax payments may be an indication of poor financial condition, the AMT sample is likely to contain firms with deteriorating financial condition which may lead to an overall decrease in accruals in 1987. This study improved three aspects of previous research designs to test the effect of the book income adjustment on financial reporting. First, the sample consisted of firms that were indeed subject to the AMT in 1987 to ensure that only the behavior of AMT firms were examined. Second, only accrued expenses and revenues that were not sensitive to other major changes in the 1986 tax law were assessed. Third, a time-series model controlling for changes in firms' financial condition was used to estimate the unexpected accruals. In general, the results indicated that firms that were subject to the AMT in 1987 exhibited unusual shifts in accounting accruals in 1986 and 1987. Unlike the institution of the AMT in 1987, the repeal of the book income adjustment in 1990 was independent of other major changes in tax law, providing a rather clean event to examine the effect of the book income adjustment on financial reporting. Evidence of accruals shifting for firms subject to the AMT in 1989 would lend further support to the conclusion that the AMT affects financial reporting practices. Accordingly, accruals of sample firms subject to the AMT in 1989 were examined. An unusual shift in accounting accruals was observed in 1989 but in a direction opposite to the 1987 sample.]

[The relation between audit opinions and auditor switching has received considerable attention in recent years. Chow and Rice (1982) report a positive association between a firm's propensity to switch auditors and the receipt of a qualified opinion in the year prior to the switch. 1 However, firms that switch auditors do not seem to receive "improved" opinions in the year following the switch (Chow and Rice 1982; Smith 1986). Despite this evidence, the Securities and Exchange Commission (e.g., Release No. 33-6594 [1985] and Financial Reporting Release No. 34 [1989]) and the popular financial press (e.g., Power 1984) continue to express concerns about opinion shopping. This study focuses on the auditor's opinion formulation process for switching and non-switching clients in the year prior to the switch. In particular, it examines the possibility that auditor switches are triggered not by the receipt of qualified opinions, but by auditors' use of conservative judgments for some clients. While conservatism refers to a number of accounting and auditing issues, the overall conservatism of the auditor is assumed to be reflected in a tendency to issue qualified opinions. An ordered probit model of the qualification decision is estimated with different threshold values for prospective switchers and non-switchers measuring different judgments applied to the two groups of clients. The results support the hypothesis that threshold values for switchers are significantly lower (more conservative) than those for non-switchers. Further analysis of switching patterns suggests that when qualified opinions are based on conservative standards, the switching rate is higher than when average standards are applied. The observed conservatism could be the auditor's reaction to negative private information gathered during the audit that makes continued association with the client uneconomical or undesirable. However, the evidence indicating that opinions do not improve after switches suggests that opinion shopping is generally futile. This condition may exist because private information is obtained during the audit process, and a client usually will not be able to shop for a less conservative auditor with a prior commitment of a favorable treatment. Recent concerns about opinion shopping and its effect on auditor independence may therefore not be justified.]

[Although health-care reform has emerged recently as an important national priority, there has been little research on the effect of possible deficiencies in both accounting and auditing standards in the development of problems in this area. This study examines earnings management in the health maintenance organization (HMO) sector of the prepaid health-care industry. HMOs are a principal component of the managed health-care concept currently being promoted as important in controlling escalating health-care costs. The study examines possible strategic behavior by HMO management in the accrual of "incurred but not reported expenses" (IBNRs). IBNRs are the costs of medical care provided to HMO enrollees during a given year but not yet reported to the HMO by the fiscal year-end. They consist primarily of five components: accrued inpatient hospitalization costs, accrued primary physician costs, accrued costs from medical specialists to whom HMO enrollees have been referred, accrued medical incentive pool payments, and other miscellaneous medical costs. Their accrual was first recommended by the Health Maintenance Organization Task Force of the American Institute of Certified Public Accountants in an issues paper later published as an exposure draft (AICPA 1985). It was eventually released as SOP 89-5 entitled Financial Accounting and Reporting by Providers of Prepaid Health Services in 1989 to be effective for fiscal years beginning on or after 15 June 1989 with earlier application encouraged. However, by the time SOP 89-5 was issued, a significant majority of HMOs was already in compliance with the SOP, at least so far as the accrual of IBNRs was concerned. The results of this study suggest that IBNRs may have been used as part of a strategic response by HMO management to events specific to the industry in the 1986-1989 period. These events included the outbreak of a premium war apparently waged to obtain market share at the expense of immediate profitability and the enactment in many states of minimum net worth regulations designed to prevent the resultant increase in financial failures among HMOs. The results suggest that the IBNRs were systematically understated by financially weaker HMOs (relative to their stronger counterparts) in order to minimize regulatory costs associated with the statutory minimum net worth requirements imposed by some states during this period. Furthermore, the results were also consistent with the political visibility hypothesis, which theorizes that highly profitable firms in politically sensitive sectors seek to reduce their visibility by adopting income-decreasing accounting methods and discretionary accruals. However, the findings were not consistent with the political visibility hypothesis if size is visualized as a proxy for political visibility.]

[This article provides evidence on the news content of managements' preliminary earnings estimates, which we define as projections of earnings conveyed in expectational language after the end of the reporting period but before the release of final earnings numbers. We examine stock price changes to assess whether a preponderance of these disclosures are interpreted as "good news" by investors, and the extent to which good news releases are disclosed earlier than bad news. Associated with preliminary earnings estimates are disclosure and timing issues. While previous theoretical work suggests managers have incentives to suppress or delay disclosure of adverse information (Verrecchia 1983; Dye 1985), studies examining the disclosure issue using management forecasts produced inconsistent results, and results on the timing of corporate earnings announcements are ambiguous. Although there is evidence on the information content of preliminary earnings estimates (Foster 1973), no study has used these data in investigating the relation between corporate disclosure and news content. Preliminary estimates are important because they embody aspects of disclosure choice similar to other voluntary disclosures such as forecasts, and the time lags between preliminary estimates and earnings releases are short, thereby assuring a strong timing aspect to their release. We document significant negative mean abnormal returns associated with the disclosure of preliminary estimates. The median is negative, but not significant at conventional levels. Tests on the timing issue indicate an ambiguous relation between disclosure timing and news content. Preliminary estimates of quarters 1-3 earnings are more likely to be bad news compared to estimates of quarter 4 and annual earnings, but within quarters there is no strong relation between news content and disclosure timing.]

[Several analytical models of the year-end inventory purchasing decision of a LIFO firm have been developed (Cohen and Halperin 1980; Halperin 1979, 1981; Biddle and Martin 1985).1 This study finds empirical support for the prediction of these models that, since only LIFO firms reduce their tax burden by purchasing additional inventory (i.e., "extra" inventory) at year-end, LIFO firms are more likely to purchase extra inventory at year-end than FIFO firms. This research also provides evidence that high-tax LIFO firms are more likely to purchase extra inventory at year-end than low-tax LIFO firms. This behavior is predicted because a LIFO firm's tax savings from purchasing extra inventory at year-end are increasing in its marginal tax rate. Additional evidence of tax-motivated year-end inventory purchases is offered by tests which find that (1) consistently high-tax LIFO firms accelerated their year-end inventory acquisitions-and thus reduced their taxable income-to a significant degree in the years immediately preceding the reduction in tax rates mandated by the Tax Reform Act of 1986; and (2) differences in tax status are not related to differences in fourth quarter inventory purchasing behavior for FIFO firms. The results of this study indicate that taxes have a sizable effect on the inventory purchasing policy of LIFO firms. For example, (1) the estimated difference in the percentage of annual inventory purchases made in the fourth quarter between high-tax and low-tax LIFO firms is equivalent, on average, to 12.66 million of purchases (3.8 percent of ending inventory); and (2) the estimated decrease in inventory purchases made in the fourth quarter by LIFO firms that move from a high-tax status in one year to a low-tax status in the following year is equivalent, on average, to 28.89 million of purchases (12.1 percent of ending inventory). These large dollar amounts lend credence to the concern that year-end LIFO inventory purchases made for tax purposes may lead to inventory management inefficiencies (Jannis et al. 1980, 186).]

[This study develops an empirical model to examine the responsiveness of budgetary allocations to public demand for services and the resulting outcome-generating activities in the New York City Police Department (NYPD). The analysis combines nonfinancial measures of the results of operations with budgetary and financial measures. The model explicitly incorporates efficiency and effectiveness measures and reflects as well the interactive nature of outcome-generating activities in the NYPD. The setting investigated suggests that, as in for-profit managerial accounting, task complexity and budgetary slack may be important conditioning variables in performance assessment. The empirical analysis uses publicly available NYPD data. We find evidence that budgetary provisions are responsive to perceived social needs. In addition, task complexity is a pervasively important determinant of both budgetary allocations (a major cost-driver) and the effectiveness of the police department in achieving specific outcomes. The data also suggest that the department may rely extensively on budgetary slack to cope with rapid changes in demand. The nature of the outcome-generating activities of the organization is illustrated in the responsiveness of outputs and outcomes to increased inputs. These results illustrate both the feasibility and the potential usefulness of comprehensive performance evaluation in the not-for-profit sector. The next section of the paper provides background on the empirical research issues and a brief review of relevant academic research. The empirical model is developed in section II. Section III reports the results of the model estimation and hypothesis tests. We discuss the implications of the results in section IV.]

[Recent attention has focused on the design of cost systems that improve measurement of product costs. Much of this work has been classified under the general heading of Activity-Based Costing (ABC). There has been little systematic analysis, however, of why an ABC system with multiple cost pools, activity drivers and allocation bases generates more accurate product costs. The intuitive argument rests on the belief that multiple cost pools and multiple activity drivers better reflect the cause and effect relation between overhead resource consumption and products. Our analysis reveals the existence of trade-offs attributable to specification error, aggregation error, errors in measurement of overhead costs and errors in measurement of product-specific units of allocation bases. Our research provides some guidance for implementing ABC systems. There are two principal results of our analysis. First, partially improving specification of cost allocation bases and increasing the number of cost pools in a costing system can actually increase specification and aggregation errors. Second, reductions in specification and aggregation errors from more disaggregated and better specified costing systems may increase measurement errors and hence errors in product costs. We assume that firms do not know actual product costs, but rather implement new cost systems by identifying better cost drivers and increasing the number of cost pools under an implicit assumption that refinements in the cost system lead to improved accuracy of product cost numbers. This assumption is warranted in many cases. However, our results suggest that such incremental refinements in the cost system may actually cause product cost errors to increase. Therefore, a firm cannot assume that refining its cost system will always lead to more accurate product costs.]