Knowledge that Transforms

2008 American Accounting Association Annual Meeting in Anaheim, the 2009 Contemporary Accounting Research/Journal of Contemporary Accounting and Economics Special Joint Symposium, and workshops at the Chinese University of Hong Kong and Shanghai University of Finance and Economics for their helpful comments

One hundred and fifty auditors participated in a study that examines whether auditors’ probabilistic judgments are closer to a Bayesian benchmark when auditors make judgments using a frequency response mode versus a probability response mode. We test a series of hypotheses that examine the effect of using a frequency response mode by professional auditors both within and outside their knowledge domain (fraud or medical case context) on assessing the likelihood of rare events. The results show that the auditors’ responses across the two case contexts (fraud and medical case) using a frequency response mode are closer to the Bayesian benchmark. In addition, we find that (1) the deviations in the auditors’ responses from the Bayesian benchmark across both response modes are significantly smaller for the fraud case in the low base rate condition only and (2) the deviations in the auditors’ responses from Bayesian benchmark for the fraud case using a frequency response mode relative to the probability response mode are smaller in the low base rate condition than the other two base rate conditions. These findings contribute to research on auditor judgment and decision-making, and demonstrate how the use of a frequency response mode can improve auditors’ assessment of fraud.

We examine the application of real options within two contexts of motion picture investment decisions by studio executives. The first is whether to continue marketing a film following its initial release in theaters (an abandonment option). The second centers on the decision to produce a sequel to an original film (a growth option). Few accounting studies have examined the use of real options but they are of considerable importance to companies managing risk through their cost structure and capital investment decisions. Specifically, a real option allows decision makers to postpone further expenditure commitment until a substantial portion of the uncertainty surrounding the investment has been resolved. Our evidence from the motion picture industry indicates that studios leave a portion of their marketing budget uncommitted until its spending is warranted. We also show that studios invest more in original films that they believe will lead to a sequel. Specifically, we find that studios spend higher production and marketing costs on films with sequels than those without, and that sequels generate higher returns on investment than non-sequels. Overall, our results suggest that the real options framework has applications for accounting research and practice by providing a basis for studying and understanding cost commitments in product or project-based settings.

We explore the role the feedback loop between firms' financial health and consumers' demand for their products plays in the auto market. We construct a simple model of an automaker making pricing and debt service (continuation) decisions while recognizing that consumers are sensitive to whether it stays in business. We show that multiple equilibria can exist in such a model, and calibrate it to match stylized facts surrounding GM's recent bankruptcy. The results suggest that while the impact of financial distress on demand substantially reduced GM's profit, bank-run-like multiple equilibria do not appear likely in this market.

We compare key CDO assumptions from two departments within the same rating agency but with different financial incentives. Assumptions made by the ratings division are more favorable than those by the surveillance department. The differences are not explained by collateral switching during the ramp-up period, a long time gap between reports, nor the collapse of the CDO market in 2007 Additionally, CDOs rated with more favorable assumptions by the ratings group were more likely to be subsequently downgraded. As the useful signals from the surveillance group were seemingly ignored, these findings suggest rating agencies bias towards high ratings.

Hart and John Moore (2008) introduce new behavioral assumptions that can explain long-term contracts and the employment relation. We examine experimentally their idea that contracts serve as reference points. The evidence confirms the prediction that there is a trade-off between rigidity and flexibility. Flexible contracts—which would dominate rigid contracts under standard assumptions—cause significant shading in ex post performance, while under rigid contracts much less shading occurs. The experiment appears to reveal a new behavioral force: ex ante competition legitimizes the terms of a contract, and aggrievement and shading occur mainly about outcomes within the contract.

We investigate the effects of the institutional settings of the US health care system on individuals' life-cycle medical expenditures. Health is a form of general human capital; labor turnover and labor-market frictions prevent an employer-employee pair from capturing the entire surplus from investment in an employee’s health. Thus, the pair underinvests in health during working years, thereby increasing medical expenditures during retirement. We provide empirical evidence consistent with the comparative statics predictions of our model using the Medical Expenditure Panel Survey (MEPS) and the Health and Retirement Study (HRS). Our estimates suggest significant inefficiencies in health investment in the United States.

Taxation and liability are compared as means of controlling harmful externalities, with a view toward explaining why the use of liability predominates over taxation. Taxation suffers from a disadvantage in the analysis: because taxes do not reflect all the variables affecting expected harm, inefficiency results, whereas efficiency under liability requires only assessment of actual harm. However, liability also suffers from a disadvantage: incentives are diluted because injurers escape suit. Joint use of taxation and liability is examined, and it is shown that liability should be employed fully, with taxation taking up the slack due to escape from suit.

We present a model in which investors decide whether or to what degree they want to allow their behavior to be influenced by “market sentiment.” Investors who choose to insulate their decisions from market sentiment earn higher expected returns, but incur a small mental cost. We show that if information is moderately dispersed across investors, even a very small mental cost may result in a significant amount of sentiment in equilibrium: Individuals who choose to be swayed by sentiment increase uncertainty about the future and make it less costly for others to be swayed by sentiment as well.