[An accurate description of the process that generates measures of funds flow (cash flow and working capital from operations) has potential importance in a variety of decision contexts. In particular, the issue of cash flow prediction has been central to standard setters. According to Statement of Financial Accounting Concepts No. 1 (FASB 1978, par. 37) "financial reporting should provide information to help investors, creditors, and others assess the amount, timing, and uncertainty of prospective net cash inflows to the related enterprise." Our first objective in this study is to provide descriptive evidence that documents the statistical patterns (e.g., seasonality, autocorrelation) of the cash flow and working capital series for a sample of firms. Although the accounting literature is replete with evidence on the time-series properties of earnings numbers, much less systematic evidence on such properties for cash flow and working capital series is presently available. Our results suggest that the time-series behavior of the cash flow series is in marked contrast to the models typically employed for accounting net income. We also provide evidence that the working capital series behaves similarly to net income. Funds flow is important in the investigation of security price effects, and the association of various measures of funds flow with security returns has been studied by Bernard and Stober (1989), Bowen et al. (1987), Schaefer and Kennelley (1986), and Wilson (1987), among others. These studies have employed cross-sectional expectation models for funds flow measures that restrict coefficients to be the same across firms. We assess the effect of such restrictions on the predictive ability of these models by comparing them with univariate time-series models that permit firm-specific estimation of coefficients. Accordingly, our second objective is to assess the accuracy of forecasts of funds flow variables generated by univariate time-series models versus those obtained from the multivariate cross-sectional models used in prior research (see, e.g., Bernard and Stober 1989; Wilson 1986, 1987). This study provides new evidence on the time-series properties of cash flow and working capital series. The empirical results indicate that the statistical patterns of the cash flow series stand in marked contrast to the well-documented characteristics of quarterly earnings data. Cash flow series are modeled parsimoniously by purely seasonal time-series models. Specifically, we provide descriptive and predictive evidence supportive of the (000)� (100) seasonal Autoregressive Integrated Moving Average (ARIMA) model as a candidate model for predicting cash flow. This model outperforms the multivariate cross-sectional models used in prior research in out-of-sample predictive ability tests. We also present evidence that working capital from operations exhibits time-series behavior virtually identical to that of accounting earnings. This results in identification of ARIMA expectation models quite similar to those popularized for quarterly earnings. Such univariate ARIMA models for working capital dominated cross-sectional regression models in tests of predictive ability.]
[A multi-year adoption period now appears to be the norm for new accounting standards issued by the Financial Accounting Standards Board (FASB). For example, FAS No. 52, which pertained to foreign currency, was issued in December 1981 and became effective in 1983, a three-year adoption period. FAS No. 71, which concerned regulation, was issued in December 1982, but became effective in 1984. FAS No. 87 on pensions was issued in December 1985 and became effective in 1987, but a key provision of this statement-the recognition of a "minimum liability"-became effective only in 1989, thereby allowing a five-year adoption period. FAS No. 96 on income taxes was issued in December 1987, but amendments under FAS Nos. 100 and 103 extended its adoption to 1990 and then to 1992, a six-year adoption period (ultimately, FAS No. 109 substantially changed FAS No. 96 and its successors). Although several early statements (e.g., FAS Nos. 2 and 8) issued late in the calendar year allowed adoption over that year and the following one, practically all FASB statements issued in the 1970s became effective on a uniform date close to their issuance. Thus, it appears that the FASB changed its adoption policy in the 1980s. The Board's main justification for an extended adoption period is to alleviate firms' implementation costs, particularly the costs of renegotiating agreements with lenders and suppliers (see, e.g., FAS No. 52, par. 147-48, and FAS No. 87 par. 259-60). Interestingly, no justification was offered for the extended adoption period of FAS No. 96 (Income Taxes), perhaps an indication that a three-year adoption period had become a norm. However, when a fourth year was added under FAS No. 100, the following rationale was given (FASB 1988, par. 8): The Board believes that the disadvantages to prepares from not having a deferral of the effective date outweigh the disadvantages to users from a one-year delay in the required adoption of Statement 96, including diversity in financial reporting from the continued application of Opinion 11 by some enterprises. Given the obvious costs imposed by an extended adoption period on financial statement users, because of reduced cross-company comparability, the FASB's policy warrants scrutiny. This is the objective of the current study which focuses on FAS No. 87 (FASB 1985a) and the related FAS No. 88 (FASB 1985b). Specifically, we consider various possible managerial motives for choosing the timing of adoption of FAS No. 87 within the allowed period, and classify these motives as involving either compliance costs (the FASB's express justification for an extended adoption period) or investor perceptions (managers' attempts to change investor expectations). We then identify the adoption timing motives that are consistent with the data derived from samples of early (1986) and late (1987) adopters. The FASB's case for extending adoption periods will obviously be supported if compliance costs figure predominantly in firms' adoption-timing decisions. Of the eight proxies for adoption-timing motives examined by us, only one-increasing reported earnings-consistently discriminates between early and late adopters. This holds for interyear (1986 vs. 1987) as well as intrayear adoptions (first three quarters of 1986 vs. fourth quarter). Of the compliance-cost motives examined, company size and the number of outstanding loans were associated with the adoption-timing decision in some cases. Overall, our analysis does not provide compelling support for the FASB's cost-reduction justification for a multiyear adoption period for FAS No. 87.]
[This study examines the effects of management forecast precision (i.e., lack of uncertainty) on equity pricing and the assessment of earnings uncertainty. Kim and Verrecchia (1991) modeled the price reaction to the public release of information as a positive function of both the unexpected component of the information and the information's precision. We test these predictions with a sample of 868 management forecasts for 1983-1986 annual and interim earnings. The use of management forecasts rather than actual earnings to test the precision hypothesis has the distinct advantage that the level of forecast precision is not directly regulated and thus may vary across forecasts. Further, managers explicitly disclose their level of uncertainty. Both this study and Pownall et al. (1993) document that most forecasts are open-interval (minimums and maximums), closed-interval (ranges), or general impressions rather than point estimates. The method used to test the precision hypothesis removes restrictions on the traditional regression of unexpected returns on unexpected earnings. Specifically, the slope and intercept coefficients that map unexpected earnings into unexpected returns can vary in the cross-section as a function of forecast precision. Our results support a direct relation between forecast precision and the importance of management forecasts for security pricing. Holthausen and Verrecchia (1990) and Morse et al. (1991) modeled a decrease in investors' consensus as a positive function of the magnitude of signal surprise and the dispersion of the perceived precision of the signal. We examine these predictions with a sample of 221 point and closed-interval (range) forecasts. We calculate whether the range of outcomes disclosed by a manager exceeds the range of Institutional Brokers Estimate System (IBES) analyst forecasts. We find this variable and the magnitude of unexpected security returns (a proxy for signal surprise) to be positively associated with increases in the standard deviation of IBES analyst forecasts. Morse et al. (1991) found the hypothesized relation between signal surprise and increase in analyst forecast variance, but were unable to separate the precision effect from the signal surprise effect. Managers' explicit labeling of forecasts as more uncertain through range disclosure permits the direct calculation of management forecast precision relative to analyst forecast precision. Our tests involve joint hypotheses of the effects of forecast precision on security prices and the credibility of managers' disclosures of forecast precision. Ajinkya and Gift (1984) developed and tested the "expectations adjustment hypothesis" which posits sufficient incentives for credible, symmetric forecast disclosure. King et al. (1990) argued that expectations adjustment also suggests credible labeling of the precision of forecasts.]
[An issue of fundamental importance to accountants concerns the qualities possessed by, or that should be possessed by, accounting information. The usual intuition is that any distortion of accounting numbers relative to the true underlying cash flows of the firm is generally undesirable from the standpoint of investors. Indeed, among the primary qualitative characteristics of accounting information championed by the FASB in their conceptual framework is reliability, which is defined as "the quality of information that gives assurance that it is reasonably free of error and bias and is a faithful representation" (emphasis added). Normative statements about the desirable qualities of accounting information are often problematic since such information typically serves multiple purposes. For example, Gjesdal (1981) identifies a decision-making role and a stewardship role for accounting information and shows that the two needs may not be served equally well. The objective of this paper is to demonstrate that "distorted" accounting information may actually be preferred if the focus is on the stewardship value of accounting information. "Distorted" accounting information is characterized as information signals that are biased relative to the expected value of the firm or that measure the value of the firm with error (white noise). Bias and noise are meant to be representative of the many inadequacies usually attributed to accounting information. Current Generally Accepted Accounting Principles prevent or delay the recognition of certain assets and liabilities and their income statement counterparts, generating what may be thought of as bias. For example, the asymmetric recognition of certain gains and losses, accounting for R&D and advertising expenditures, and the absence of information about customers and suppliers in current financial statements imply that the consequences of certain current managerial activities are not reflected in accounting information. This is bias. Similarly, current Generally Accepted Accounting Standards require numerous estimates generating what may be thought of as noise. For example, subjective assessments such as estimated useful lives of assets, loss contingencies, impairment of asset values, and the allocation of purchase price to individual assets and liabilities in corporate acquisitions are likely to introduce noise into accounting information, even in the absence of bias. A crucial assumption underlying our analysis is that managers allocate effort across many managerial activities, all of which contribute to improving the value of the firm. For example, we can imagine an executive dividing his energies across activities like controlling costs, implementing total quality management initiatives, developing a well-trained workforce, and creating an operating environment where innovation can flourish. While activities such as these have cash flow implications for a firm, we argue that it is difficult, or impossible, to disaggregate the results of operations into individual performance measures that cleanly isolate the effects of the different activities. As a result, compensation contracts in our analysis are based on aggregate performance measures such as accounting income and share price that do not unambiguously distinguish between individual managerial activities.1 This does not preclude the use of detailed or disaggregated accounting information other than net income as a measure of managerial performance. Rather, it captures the idea that accounting systems cannot realistically measure the economic consequences of all managerial activities in detail. Some aggregation is inevitable, and this imposes a contracting constraint.2 In our model, limiting the available performance measures to accounting information and share price renders efficient managerial incentives unattainable and creates a potential contracting value for bias and noise.3 Given that aggregated accounting information and share price are the only available performance measures, we derive conditions under which biased accounting information can be effectively utilized to mitigate the limitations of aggregated measures by better balancing incentives across different managerial activities. In particular, we show that biased accounting information, even if it contains substantial noise, can be better than unbiased accounting information, even if it contains no noise, given that price is also available as a measure of managerial performance. As long as there is a need to provide different incentives for different managerial activities, there is a need for biased accounting information since bias enables the de facto observation of the individual components of output. In addition to examining the role of biased accounting information, our analysis demonstrates the benefits of noisy accounting information. This suggestion seems counterintuitive since noise imposes risk on the manager without generating any benefits. While the usual intuition holds in most settings, it fails to recognize that there may be an equilibrium relation between accounting information and an endogenously determined share price. A reduction in the level of noise in accounting information motivates investors to curtail private information acquisition, which dilutes the information content of price and thus lessens the usefulness of price as a measure of managerial performance. Therefore, the optimal level of noise in accounting information is a tradeoff between the usefulness of price relative to the usefulness of accounting information as measures of managerial performance. It is important to emphasize that, in this paper, the benefit of distorted accounting information (bias or noise) that accrues to shareholders is independent of any managerial motivations to manipulate the disclosure system that characterize the "earnings management" literature (see Schipper 1989). Moreover, by focusing exclusively on the stewardship value of information, we show that bias and noise are desirable because they create a "bigger pie" to be shared by all. However, we do not consider the impact of bias and noise on other aspects of shareholder welfare. Bias and noise in accounting disclosures will also impact investors' risk-sharing opportunities both through the direct effect of the distorted public disclosure and the indirect effect on private information acquisition (see, e.g., Diamond 1985). Any overall equilibrium, of course, would have to consider the interaction of all these forces. The exact nature of these tradeoffs remains an unresolved issue.]
[Disclosure of financial information is an essential ingredient of a well-functioning capital market. However, public disclosure of information can affect a disclosing firm negatively if market participants make strategic use of the information to their advantage. In the presence of such a "proprietary cost," a firm has to trade off the positive and negative effects of disclosure. In an oligopolistic environment, disclosure causes rival firms to respond. The response depends on the nature of competition and private information. Some firms benefit by hiding, and others by sharing, information. If firms do not disclose information voluntarily, mandating disclosures will force firms to disclose information that they wish hidden. Mandating has no incremental effect if firms would have voluntarily disclosed the information. To promote more efficient (welfare-maximizing) disclosure policies, it is essential to understand how firms would behave in the absence of mandatory disclosure requirements. The purpose of this article is to analyze that behavior. A two-stage model of a duopoly is formulated to analyze firms' incentives to disclose private information. The incentives depend on whether firms are engaged in Cournot or Bertrand competition, and whether the private information is about demand or cost. Both ex ante incentives to precommit to a disclosure policy and ex post incentives to disclose voluntarily are examined. Ex ante, firms would not commit to disclosure in Cournot/demand and Bertrand/cost cases. Although Cournot duopolists would not commit to disclosure of information about demand, both firms and consumers might be better off if disclosure were enforced by regulatory agencies such as the Securities Exchange Commission (SEC) or the Financial Accounting Standards Board (FASB). Firms would commit to share information in the cases of Cournot/cost and Bertrand/demand. However, firms' incentives diverge ex post because the benefit of disclosure depends on the realized value of the signal. When the existence of private information is suspected, but not disclosed, nondisclosure is attributed to the type of signal that is better undisclosed. Thus, in equilibrium, it is difficult for firms to hide information successfully. In the Cournot/demand case, virtually all values of private information would be disclosed. In contrast, in Bertrand/cost, disclosure would seldom be observed when products are good substitutes. The model developed in this article identifies the environments in which mandatory disclosure rules are most effective: (1) when firms have the incentive to precommit to nondisclosure and (2) when voluntary disclosure is least likely in the absence of precommitment.]
[A major concern in the literature is that participation by subordinates may result in the generation of slack budgets (Antle and Eppen 1985). In one of the earliest studies, Williamson (1964) concluded that subordinate managers will try to influence the budget-setting process and obtain slack budgets. In conformance with Merchant (1985a), Lukka (1988), and Young (1985), budgetary slack is defined as the express incorporation of budget amounts that make it easier to attain. Managers may build slack into budgets by strategies that understate revenues and overstate costs (Schiff and Lewin 1970). Whether budgetary slack is a likely outcome in all participatively set budgets is a matter of conjecture. Lukka (1988) argued that a high degree of participation gives subordinate managers the opportunity to contribute directly to the creation of slack, and vice versa. However, the link between participation and slack is equivocal, since Cammann (1976), Merchant (1985a), and Onsi (1973) provide evidence that participation may lead to a reduction in slack, which can be attributed to the positive communication between managers so that subordinates feel less pressure to create slack. The literature proposes a link between participation and budgetary slack through two variables: superiors' budget emphasis in their evaluation of subordinate performance, and the degree of information asymmetry between superiors and subordinates. When participation, budget emphasis, and information asymmetry are high (low), slack will be high (low). For this study, samples of managers were drawn from manufacturing organizations in the Sydney, Australia, metropolitan area. Measures of budgetary slack and information asymmetry were developed. Support was found for low (high) slack when the predictors are high (low).]
[Current policy on how auditors should limit uncertainty about misstatements in auditee assertions is based on the audit risk model (AICPA 1992) that decomposes the components of audit risk as inherent risk (IR), control risk (CR), and detection risk (DR). The literature on the audit risk model has focused on a priori analyses of the model's assumptions and implications (see, e.g., Cushing and Loebbecke 1983; Kinney 1983, 1989, 1992; Leslie 1984), and auditors' risk assessments in experimental settings (see, e.g., Colbert 1988; Daniel 1988; Jiambalvo and Waller 1984; Libby et al. 1985). Absent are empirical studies that examine applications of the model in field settings. This article reports empirical evidence on auditors' IR and CR assessments in field settings by analyzing archival data drawn from the audit workpapers of KPMG Peat Marwick. As a part of audit planning, the firm requires its auditors to make and document IR and CR assessments for each assertion of each significant account.1 The assessments are made with respect to tolerable error, an algorithm-based measure of planning materiality at the assertion level.2 The data include approximately 5,000 risk assessments at the assertion level for trade accounts receivable, inventory, and trade accounts payable, on a total of 215 audit engagements. The data also indicate, for each assertion, whether a misstatement exceeding tolerable error was detected by the auditor. The data analysis considers four issues, the first of which is whether there is a statistical association between auditors' IR and CR assessments. A priori researchers (e.g., Cushing and Loebbecke 1983) argue that the audit risk model's multiplicative combination of IR and CR suggests independence between risk components, which contradicts auditors' conventional wisdom of dependence. The analysis in this study concludes that the dependence problem arises because (1) its event structure is ill-defined and (2) it fails to recognize that an auditor's assessments are conditional on his or her knowledge. A knowledge-based dependence may produce a statistical association between IR and CR. Contrary to expectation, the empirical evidence supports the conclusion of an insignificant association between IR and CR; however, in a predominance of cases, CR is assessed at the maximum probably for reasons of efficiency. The remaining issues pertain to the policy requirement of assertion-level risk assessments. Viewed generally over many audit engagements, current policy depends on the following premises: (1) the rate of misstatements varies over assertions, (2) auditors' risk assessments vary over assertions, and (3) the association between the rate of misstatements and auditors' risk assessments is positive (i.e., the assessments are accurate). The data analysis examines the empirical validity of each premise, and supports the first inasmuch as there are significant differences in the rate of detected misstatements over assertions for each account. However, auditors typically assess IR and CR at the same value for all assertions for an account, which is inconsistent with the second premise. When the data pertaining to all assertions for an account are included in the analysis, the association between IR and the rate of detected misstatements (after controlling for CR and DR) tends to be positive but low, which indicates modest support for the third premise. When the analysis includes only the "most important" assertion for each account, the association is considerably stronger. In general, auditors' risk assessments are consistent with a heuristic that deliberately assesses risk for an account's "most important" assertion but does so mechanically for other assertions. Taken as a whole, the results indicate a need either to reconsider the policy of multiple risk assessments for an account or to enhance auditors' ability to assess assertion-specific risk.]
[Auditor liability is a growing concern of public accounting firms (Collins 1985; Flynn et al. 1990; Mednick 1987; Minow 1984). In lawsuits brought by clients for breach of contract and tort actions for negligent execution of an audit, as well as in an increasing number of lawsuits brought by third parties, a common defense is the auditor's compliance with generally accepted auditing standards (GAAS). In this study, the source of professional auditing standards was manipulated to examine its influence on jurors' decisions. Four fact patterns were presented to members of jury pools called to jury duty. Prospective jurors responded to a fact pattern by voting in favor of either the plaintiff/client or the defendant/auditor. The fact patterns were manipulated to compare jurors' responses to standards of auditing performance established by the federal government versus those established by the auditing profession. In addition, a comparison was made of jurors' responses to two sets of instructions provided by the judge: either that standards alone set the required level of performance or that standards are only a part of the evidence to be considered in establishing the required level of performance. At trial, a judge's instructions to the jury before its deliberations can be influenced by counsel for the public accounting firm as to the evidentiary weight assigned to professional standards. The results that follow indicate that jurors are more likely to rule against a CPA firm when the profession's standards are offered in defense and less likely to rule against it when government standards of performance are offered in defense. Also, as expected, jurors are more likely to accept standards in defense, whether established by the government or the profession, if the judge identifies the standards as the only criterion for an expected level of performance rather than as only part of the evidence.]
[This research examines the effect that adoption of earnings-based incentive plans has on performance and capital expenditure policy in the motor carrier industry. The motor carrier industry provides the opportunity to study the effect of incentive plans on small, closely-held organizations. Restricting the sample to a single industry controls for variations in accounting procedures, heterogeneous production functions, and other environmental factors. Firms that adopted bonus and performance plans are matched with similar firms without such plans. The matching criteria are size, carrier type, and freight classification. The dependent variables are operating ratio, net income, capital expenditures, and maintenance expenditures. The analysis investigates the extent to which the groups differ in performance and investment policy before and after plan adoption. The results indicate that motor carriers that adopted bonus plans had out-performed the respective control firms during the post-adoptive period. This relatively improved performance is not linked to reductions in capital or maintenance expenditures. Although the results for performance plan adopters are in the expected directions, they are not statistically significant.]