Knowledge that Transforms

[This article relates the efficiency of nonprofit organizations to the composition of their board of trustees. Following arguments by Fama and Jensen (1983a, 1983b) and Williamson (1983), we conjecture that nonprofit organizations are more efficient if their board of trustees have a larger proportion of outsider trustees rather than insider (employee) trustees since the former are presumed to have a greater incentive to monitor the organization and the latter are presumed to have a greater incentive to consume perquisites. This conjecture is tested empirically for a sample of 72 charities with a specific health focus, with respect to both the technical and allocative efficiency of the organization. Technical efficiency indices were derived by using data envelopment analysis (DEA) under various assumptions concerning the industry production technology, including the assumption that charity outputs are not substitutable for each other. These indices are reasonably well measured since the data included information on volunteer labor, a necessary input for charity services. To test the conjecture that the technical efficiency of the organization is affected by the composition of the board of trustees, the estimated indices of technical efficiency were regressed on the board's proportion of insider trustees and the organization's debt-value ratio. The conjectured relationship was not confirmed by the data. As an additional test, the proportion of insider trustees was replaced by the ratio of insider-trustee remuneration to total labor remuneration, the argument being that the greater the relative remuneration received by the insider trustees, the more capable they might be in appropriating perquisites of all types. As before, the results did not confirm the conjectured relationship, leading us to conclude that the technical efficiency of nonprofits is not affected by the composition of the board of trustees. To determine the relationship, if any, between the allocative efficiency of the organization and the composition of the board of trustees, charity costs were multiplied by the technical efficiency index so that any remaining cost inefficiencies are allocative in nature. This adjusted cost was then regressed on the proportion of insider trustees on the board (or the proportion of insider-trustee remuneration) and the organization's debt-value ratio. The conjectured relationship between allocative efficiency and the composition of the board of trustees was also not confirmed by the data.]

[The objective of this study is to evaluate the debt covenant hypothesis by using the details of lending agreements at the time of the FAS No. 19 Exposure Draft. If adopted, FAS No. 19 would have eliminated the use of the full-cost method for firms involved in oil and gas exploration. Several studies found a significant difference between the abnormal returns of full-cost and successful-efforts firms in response to the release of the FAS No. 19 Exposure Draft (Collins and Dent 1979; Lev 1979; Lys 1984), and this has been hypothesized to result from possible effects on accounting-based covenants in debt contracts. However, empirical tests were indirect in that variables of financial leverage were used as proxies for debt covenant effects. According to the debt covenant hypothesis, firms choose accounting methods to maximize slack in debt covenant constraints. Mandatory changes in accounting methods might bring some firms closer to violating their debt covenants. Borrowing firms, however, can anticipate the possibility of such regulatory change and protect themselves, for example, by completely specifying the accounting methods that will be used to determine covenant compliance, regardless of subsequent changes to generally accepted accounting principles. When outstanding debt contracts are so structured, the probability of default on accounting-based covenants could be unaffected by GAAP changes. Financial leverage variables fail to distinguish between firms with and without such protection. Using exhibits to SEC filings, I examined 83 debt contracts in effects in 1977 for each firm in a sample of 35 full-cost firms. I identified 13 firms that had at least one covenant that would have been affected by FAS No. 19. Portfolio tests indicated that these 13 firms drive the difference between the returns of full-cost and successful-efforts firms in the full sample. An alternate set of portfolios based on leverage as a proxy for debt covenant effects showed no relation to those based on actual debt contracts and also failed to explain the stock price response to the Exposure Draft release.]

[The Tax Reform Act of 1986 reduced individual income tax rates below that of corporations. The fear that this would lead to a systematic disincorporation has not apparently materialized since the major stock exchanges report that only about 100 partnerships were traded during the next five years. Scholes and Wolfson (1992) suggest that this result is predictable because of the additional nontax costs of operating as a partnership, which include increased transactions costs, more restricted access to capital markets, and less control over management. Guenther (1992) and Terando and Omer (1992) provide evidence that firms must have considered both tax and nontax costs when choosing organizational form. This study examines whether the factors taken into consideration in organizational form choice also affected the market value of a sample of firms in the oil and gas industry during the period 1985-1988. We chose for our tests a valuation model used by Harris and Ohlson (1987) and others since many of the publicly traded (master limited) partnerships (MLPs) were created in the oil industry. The studies by Guenther (1992) and Terando and Omer (1992) show that MLPs generally had only one line of business, less debt, and higher dividend yields than their corporate counterparts. These differences are predictable in view of the tax consequences of operating in the partnership form. Guenther also finds MLPs to be less profitable, which is consistent with higher nontax costs of the partnership form. We show that MLPs invested significantly less in exploration for new deposits. The combination of the lower exploration expenditures, higher dividend yields, and poor financial performance suggests that MLPs may have been set up as limited-life entites to distribute assets to their unit holders in a tax-efficient manner. We extend the Harris and Ohlson (1987) valuation model by adding dividends and exploration levels. Exploration levels are found significant for both MLPs and corporations, but dividends are relevant only in the MLP model. We also find that dividend levels are significantly explained by asset values only for the MLPs. These valuation differences are consistent with tax-motivated organizational form choice and the perceived passive nature of the MLPs.]

[We present empirical evidence that prior accounting information, such as capital expenditure, retained earnings, funds from operations, and dividend history, is useful in explaining cross-sectional variations in the market response to stock dividend announcements. An important accounting issue concerns the information content of disclosures and their usefulness to the investor. We demonstrate the complementary role of previously disclosed firm-specific accounting information in the market's assessment of subsequently disclosed information. Thus, two firms declaring the same amount of stock dividend may experience predictably different market reactions to the announcement when it is conditioned by prior information about the firms. Comparable research by Kane et al. (1984) has shown that changes in earnings and dividends either corroborate or contradict prior information. A broader approach by Gonedes (1978) and Antle et al. (1991) shows that the sequence and history of information arrival are relevant in interpreting the information content of accounting signals. Ou and Penman (1989) demonstrate the role of prior accounting information in predicting earnings changes in subsequent periods, and John and Lang (1991) have shown, both theoretically and empirically, that the market uses information about prior insider trading to interpret the information content of dividend changes. Stock dividends are appropriate for an investigation of the complementary role of prior accounting information because their issuance is largely a paper transaction, and because they have been interpreted as a signal of better future prospects. Although significant positive abnormal returns usually accompany stock dividend announcements, alternative (and more credible) instruments could signal future prospects (such as an increase in cash dividends). The uncertainty about how investors interpret stock dividend distributions suggests a role for previously disclosed accounting information as a conditioning factor. A survey of managers of firms declaring stock dividends (Eisemann and Moses 1978) indicates that such distributions are intended either to conserve cash in difficult times or to express confidence in the firm, two diametrically opposed motivations. So one firm may declare stock rather than cash dividends in order to invest in more profitable ventures, and another may do so because it faces operating losses and a severe cash crunch. Absent other information, it is likely that the market will respond negatively when cash dividends are discontinued or decreased and replaced by stock dividends (Shefrin and Statman 1984). Other firm-specific accounting information, however, such as capital expenditure (which reflects new investments) and funds from operations (which reflect cash availability), may also influence investor responses when considered in conjunction with dividend history.]

[We test several categories of ratios-short-term liquidity, performance measures, earnings per share (EPS), capital structure, and the gross margin ratio-to determine if they have equilibrium values or follow a random walk. For ratios with an equilibrium value, the speed at which the ratio returns to equilibrium from out-of-equilibrium conditions is measured. Since equilibrating forces may differ with firm size, we also test for differences in adjustment speeds between small and large firms. An accounting ratio may have an equilibrium value if management targets a certain ratio so that any deviation from the target causes management to initiate actions that will return the ratio to target. Also, although management may not be targeting a ratio, the interaction of management's actions with external market industry forces may lead to an equilibrium value. We investigate the total adjustment over time and then assess both the relative adjustment speed and the relative weights of the two main equilibrating forces: industry and management. The statistical technique used allows each firm to have its own, unknown equilibrium value. In addition, we remove an important sampling bias in measuring the autocorrelation coefficient. The results show that when firms experience a liquidity shock, equilibrating forces counterbalance a little more than a third of the shock in the next period. This finding suggests that firms' liquidity ratios have a fast adjustment to equilibrium values. EPS ratios also have a high adjustment rate to equilibrium value; about one-third to one-half of the shock is adjusted within one period. For performance measures (net operating income over sales or assets), for the equity to debt and gross margin ratios, the findings imply a relatively long adjustment process to equilibrium values. Supplementary tests suggest that smaller firms adjust their ratios to the optimal target more swiftly than large firms. Separating the ratios' total adjustment effect into industry and management components provides evidence that the adjustment rates differ for different industries. On average, the management adjustment is faster than the industry effect. A weighting measure suggests that both industry and management contribute a significant share to the total adjustment. Tests of the predictive power of the model show that historical control of performance ratios is correlated with future actual performance. Also, firms that were acquired showed better than average control of their liquidity and performance ratios and showed a destabilization of their equilibrium EPS ratios. Finally, comparing the adjustment rate with a sample of firms from an earlier time period shows a stability of the adjustment behavior over time. Information about the existence of equilibrium ratios and their adjustment speeds can help predict future values or events, and identify firms in special categories, for example, firms that will be acquired. It can also help in the evaluation of managerial actions insofar as managers have control over aspects of the financial ratios examined.]

[Recent audit studies by Brown and Solomon (1990, 1991) reveal that careful consideration of domain-specific knowledge can result in the experimental detection of configural relationships between information cues. These findings suggest that auditors' decisions may be more complex than indicated by some previous research, and that additional research is necessary to identify conditions in which auditors utilize configural processes. This study investigates the role of environmental risk factors on the configurality of audit decisions. That is, we test whether the systematic consideration of audit risk variables results in the identification of higher order, interactive decision processes where linear relationships have previously been detected. The findings of Libby et al. (1985) and existing audit pronouncements are used to develop hypotheses regarding auditors' internal audit decisions. The hypotheses concern (1) the interactive effect of inherent risk and control strength on the extent to which auditors rely on internal audit functions to reduce planned audit work and (2) the extent to which these environmental factors affect consideration of three components of internal audit quality: objectivity, competence, and work performed. Audit managers from a Big Six accounting firm responded to a series of audit-planning cases concerning the receivables cycle of a mediumsized manufacturing firm. Inherent risk and strength of control architecture were manipulated as between-subject variables, while the objectivity, competence, and work of the internal auditors were manipulated within subjects. The results indicate that specific audit decisions are quite complex when elements of the risk environment are explicitly considered. Specifically, reliance on the internal audit function was based on a configural relationship between the levels of inherent risk and control strength. Auditors relied more on internal auditors when control architecture was strong rather than weak in conditions of high inherent risk. However, the effect of control architecture was mitigated when inherent risk was low. Also, complex relationships existed between environmental risk and task-specific components of internal audit quality. For example, auditors considered all three internal audit components when making reliance decisions in the high inherent risk and strong control strength condition, but not in certain other risk conditions. Implications of the experimental results are discussed.]

[In a recent study, Hayes and Millar (1990) presented empirical evidence on the cost function and apparent cost-optimizing behavior of the local managers of 33 county jails in Tennessee. Two main arguments were advanced: (1) line-item budgeting (LIB) was an ineffective control because the cost shares are assumed fixed in such budgetary settings, and (2) the budgetary control and performance evaluation process in not-for-profit settings could be improved if the underlying cost function was estimated by using a flexible functional form such as the translog to gain knowledge of possible input substitution and output transformation. This translog budget model was viewed implicitly as a superior alternative to the more traditional LIB approach. The main objective of this study is to extend Hayes and Millar's idea of a translog budget model by outlining a more complete budgetary system. It is shown that a frontier cost function generated from the ordinary least squares (OLS) translog function can be used to identify four types of inefficiencies: the degree of technical, allocative, and scale inefficiency as well as institutional X-inefficiency (Liebenstein 1966). These four types of inefficiencies are then linked to both the long-term and short-term objectives of budgeting; namely, performance evaluation, subordinate manager motivation, planning, and control. The second objective of the study is to compare the translog budget model (as revised) against the most frequently applied alternative technique, the nonparametric data envelopment analysis (DEA), in the same context. From the standpoint of a routine budgetary control system, it was found that the DEA model is more suitable than the translog model. In not-for-profit settings, however, an econometric model such as the translog may be needed initially in the specification of the most appropriate input and output measures. Although the effectiveness of LIB as a control is not addressed directly, our analysis shows that the line-item data mandatory with this approach is an essential part of any effective budgetary system designed for a not-for-profit setting.]

[Prior research suggests that option trading affects the availability and timeliness of predisclosure information about firms and that the price-earnings relation is influenced by characteristics of the predisclosure information environment. Motivated by these research findings, this study (1) examines various firm-specific attributes that are likely to explain the different information environments of firms with and without exchange-traded options, and (2) investigates the price-earnings relation of such firms. The price-earnings relation is examined in both "event study" (short-window) and "association study" (long-window) contexts. The short-window analysis tests the hypothesis that the "surprise" in quarterly earnings reports (measured by the abnormal stock return variability around earnings announcements) is greater for nonoption firms than for option firms (hypoth. H1). The long-window analysis tests the hypothesis that security prices signal future earnings changes earlier for option firms than for nonoption firms (hypoth. H2A). The hypothesis also predicts that nonoption firms are more likely than option firms to exhibit post-FYE (fiscal year-end) drift (hypoth. H2B). The results indicate that option firms are associated with five firm-specific attributes: (1) larger firm size, (2) higher institutional concentration, (3) higher analyst coverage, (4) higher trading volume, and (5) more Wall Street Journal Index news releases. Based on 3,721 quarterly earnings announcements of 431 firms during the 1980-1983 period, the results support the first hypothesis; abnormal return variability surrounding quarterly earnings announcements is significantly greater for nonoption firms than for option firms. To examine how the five firm-specific attributes provide alternative explanations for the observed results, the empirical tests are repeated by using a unilateral matching approach. Five subsamples (each based on one of the five variables) are constructed. The results for each support the first hypothesis. In addition, a control portfolio is constructed that conservatively controls for the five proxy variables (i.e., the nonoption firms in this portfolio are associated with larger firm size, higher institutional concentration, higher analyst coverage, higher trading volume, and more Wall Street Journal Index news releases). With a relatively smaller sample size, the control portfolio results also support the first hypothesis. Finally, multiple regression results indicate that option trading possesses incremental explanatory power over the other variables in explaining the differential content of earnings releases for option and nonoption firms. The only other variable that is significant in the regression analysis is the number of Wall Street Journal Index news releases, which is negatively related to measured information content. This suggests that press coverage is also an important variable in explaining cross-sectional differences in information content, at least for the sample firms. With respect to the second hypothesis, the results for the entire sample, the matched subsamples, and the control portfolio indicate that the security prices of option firms anticipate accounting earnings earlier than do those of nonoption firms. For option firms, about 50 percent of the price change associated with economic events contributing to the current year's earnings change is realized in the previous fiscal year. For nonoption firms, however, a significant portion (about 70 percent) of the price change associated with the earnings change occurs in the current fiscal period and in the 12 months following the fiscal year-end. In addition, the magnitude of the post-FYE drift is greater for nonoption firms than for option firms. Certain important caveats apply to the results. First, given that the tests for the matched subsamples attempt to control only for one factor at a time, the results are subject to a missing-variable problem. Second, while the option-trading variable exhibits statistical significance in the regression analysis, the explanatory power of the full regression is low (although it is similar to that achieved in typical cross-sectional analyses of abnormal security returns). Finally, given the lack of a formal theory concerning option trading and information flows, it is difficult to infer that option trading causes the differences in the price-earnings relation across firms.]