Knowledge that Transforms

[Managers frequently choose the amounts to expend in various activities simultaneously rather than sequentially. Quality costs provide a common example. When managing quality, decisions to invest in different types of prevention activities are made jointly. For example, spending more on maintenance simultaneously reduced the spending necessary on supervision. Similarly, scrap costs are often traded off against the costs of prevention and appraisal activities. Our article is motivated by field observations at an automobile lamp manufacturing plant. Specifically, we estimate two observed effects: (1) the influence of lamp design on the consumption of overhead resources during manufacturing (e.g., the effect of multicolor designs on supervision costs) and (2) the interdependence among supervision, maintenance, and scrap costs. One way to understand cost drivers and manage costs is to employ an activity-based costing approach (Cooper and Kaplan 1991, chap. 5; Young and Selto 1991). With this approach, prevention costs of supervision and maintenance are allocated to products on the basis of hours of supervision and maintenance, and scarp costs are apportioned on the basis of physical scrap levels. Quality-related costs are reevaluated after products are redesigned and processes reconfigured to determine if quality related costs have indeed decreased. With such an approach, simultaneous effects of costs are not estimated. In our approach, we simultaneously estimate interdependencies among activities. Instead of supervision hours, maintenance hours, and physical scrap levels, we use product and process design variables as cost drivers of supervision, maintenance, and scrap costs. Selecting product and process variables as cost drivers allows us to estimate the effect of alternative lamp designs on quality costs incurred during manufacturing. We also explicitly consider simultaneity. For example, our estimation procedure recognizes that maintenance costs affect supervision costs and vice versa and that both costs are affected by product and process design choices. Our analysis provides valuable information to managers. At our site, designers use quality costs associated with different design features to guide future product designs and modifications. Similarly, as operations managers experiment with different methods to manage complexity, the simultaneous cost estimation enables them to evaluate which prevention activities are successful in reducing scrap.]

[Firms are redesigning operations to reduce slack and waste and improve performance (Hoerr 1989; Safizadeh 1991; Walton 1987) and this often involves reorganizing production workers into workgroups to foster cooperation and group participation in setting standards (Hayes et al. 1988; Schonberger 1986). In addition to employing incentive schemes linked to meeting standards, many firms are using bonuses tied to relative performance among groups to develop a spirit of intergroup competition. Over the past two years, we made several visits to three Fortune 500 manufacturing firms involved in such changes.1 The site visits suggested several hypotheses that merited further investigation. Thus, we designed a laboratory experiment to study more systematically what we had observed in the field. This study extends previous research on determinants of slack and performance (e.g., Chow 1983; Chow et al. 1988; Waller and Chow 1985; Young 1985) by: (1) incorporating our observations and the literature on intragroup cooperation and competitive feedback to develop hypotheses, (2) studying workgroups rather than individuals, and (3) using a multi-period rather than single-period setting. Results of the experiment show that the type of competitive feedback received by groups affected both their output and slack. Interestingly, when individuals were allowed to cooperate rather than work in isolation, performance actually declined. This latter result was unexpected and was likely the consequence of the particular experimental task.]

[We formulate and test the hypothesis that nonearnings disclosures of small, but not large, firms generally are "good news." Nonearnings disclosures are defined as disclosures by managers and outsiders about news other than earnings (e.g., stock splits, takeovers, new orders). "Good news" is defined as a positive stock price reaction at the time of the information disclosure. Our hypothesis is motivated by two lines of prior research. First, managers have incentives to disclose their private information voluntarily when they expect the effects of the information on firm value to exceed the disclosure costs (Verrecchia 1983). Second, the "firm-size differential information hypothesis," advanced by Atiase (1980, 1985) and the corroborating empirical evidence of Atiase (1985, 1987), Freeman (1987), and Bhushan (1989) suggest that incentives for information production and dissemination by outsiders are an increasing function of firm size. Thus, assuming that nonearnings disclosures concerning small firms are initiated primarily by managers, whereas those of large firms are not, small (but not large) firms' nonearnings disclosures are more likely to be good rather than bad news. Using firm-specific nonearnings disclosures, identified from the Dow Jones News Retrieval Service data base over the 1982 to 1987 period, we show that small firms' nonearnings disclosures, on average, are associated with significant stock price increases, whereas large firms' nonearnings disclosures, on average, are valuation-neutral. Given these results and the evidence that nonearnings disclosures are often made around the time of earnings announcements (Hoskin et al. 1986; Thompson et al. 1987), we reexamine the puzzling result of Chari et al. (1988) that on-time earnings announcements of small, but not large, firms are associated with positive abnormal returns, unconditional upon the nature of the earnings news. We hypothesize that this phenomenon is attributable to nonearnings disclosures of good news around the time of small firms' earnings announcements. We show that small and large firms' "pure" on-time earnings announcements are not associated with positive abnormal returns, and that small (but not large) firms' "contaminated" on-time earnings announcements are associated with positive abnormal returns. We conclude tht the Chari et al. (1988) results do not pertain to small firms' on-time earnings announcements per se, but to those that are accompanied by nonearnings news.]

[The primary purpose of this study was to investigate how auditors' belief revisions and evidence search are influenced by the frame of the hypothesis being tested and by confirmation bias and professional skepticism (conservative bias). This study is distinguished from prior research in three main ways. First, the effects of confirmation bias and professional skepticism on the complementary audit functions of evidence evaluation and evidence search are examined jointly in the same experiment. Second, unlike many studies which have examined belief revisions of auditors solely under an error frame (Ashton and Ashton 1988, 1990; Tubbs et al. 1990), this study examines the judgments and behavior of auditors operating with both environmental (nonerror) and error-framed hypotheses. Third, the full effects of confirmation bias and professional skepticism were enhanced by having the subjects establish their own hypothesis frame and likelihood assessments, rather than respond to preset conditions. Confirmation bias implies that auditors may seek to confirm their hypotheses and so may favor information that confirms rather than refutes their initial assessments. This approach could lead to premature closure on a belief or hypothesis. Professional skepticism implies that auditors focus more on error-related evidence. An approach that is too conservative may lead to the performance of unnecessary audit procedures and thereby reduce audit efficiency. Environmental conditions refer to economic changes, changes in the industry and geographic area in which the company operates, or changes in company policies regarding investment, marketing, and financing strategies. Error conditions refer to intentional or unintentional misstatements in the financial statements. A field experiment was conducted in which auditors reviewed preliminary audit information and then indicated whether they favored an environmental or an error-framed hypothesis as the most likely explanation of an observed fluctuation in financial statement ratios. A likelihood assessment was assigned to the favored hypothesis frame, and the auditors were then asked to seek information to test their initial hypothesis from a list of audit questions. After evaluating the audit cues, the auditors updated their hypothesis beliefs and continued their evidence search. The results of this study indicate that auditors reacted differently to audit evidence, depending upon the frame of the hypothesis they favored and their belief extremity. Specifically, auditors who favored the error frame reacted more strongly to both confirming and disconfirming evidence than did those who favored the environmental frame. Furthermore, in conformance with the findings of Ashton and Ashton (1988, 1990) and contrary to Bamber et al. (1991), the auditors were more responsive to disconfirming evidence than to confirming evidence when belief revision was measured with an absolute scale. However, when the relative change in belief revision was measured with a proportional scale, the magnitude of response with confirming evidence was not significantly different from that with disconfirming evidence. The auditors' continued evidence search was conditioned by a conservative bias irrespective of the hypothesis frame favored or belief extremity; that is, their search strategy emphasized the uncovering of potential material errors (Smith and Kida 1991). Because the conservative bias was stronger for auditors who favored the error frame, confirmation bias may partially account for this effect by enhancing the emphasis on error. Conversely, confirmation bias may have somewhat weakened the effect of conservative bias for those auditors who favored the environmental frame.]

[This paper examines the stock price effects of alternative types of management earnings forecasts. Beyond deciding whether to disclose forecasts, managers must decide whether to issue a point projection or a more qualitative estimate (e.g., a bounded range), and whether to project interim or annual earnings or both. Our empirical tests assess differences in the information content of management earnings forecasts that differ by form and horizon. Our tests provide a comprehensive investigation of the price effects of these alternative forecast disclosure types. While an extensive literature exists on the relation between management forecasts and stock prices, most previous studies examine only point and range forecasts of annual earnings (e.g., Penman 1980; Ajinkya and Gift 1984; Waymire 1984; McNichols 1989; Pownall and Waymire 1989). Exceptions include Lev and Penman (1990), Patell (1976), and Baginski et al. (1993). Lev and Penman (1990) include lower and upper bound forecasts for part of their sample period, but do not examine these disclosure forms separately. Patell (1976) provides evidence on mean price changes associated with a pooled sample of annual minimum and maximum forecasts. Baginski et al. (1993) examine alternative forecast forms. Prior analyses of managers' disclosure incentives speculate that investors may condition their assessment of forecast information on disclosure form and horizon. For instance, King et al. (1990) suggest that forecast disclosures emerge as voluntary managerial actions to reduce costly information asymmetry in capital markets. Under the "expectations adjustment" hypothesis, managers have incentives to acquire and maintain a reputation for credible disclosure. Rational investors recognize that disclosure quality varies systematically by disclosure form and will discount qualitative projections or those issued with longer horizons. Policy debates on mandatory disclosure of qualitative information, such as the recent SEC debates over the content of "Management Discussion and Analysis" disclosures, and deliberations on forecast disclosure in the 1970s (see King et al. 1990), also suggest a need for evidence on the information content of qualitative prospective disclosures and alternative forms of forecasts.1 Our primary tests are based on a sample of 1,252 forecasts disclosed by 91 firms between July 1, 1979 and December 31, 1987. Several conclusions emerge from these tests. First, forecast disclosures remain highly informative even when including other disclosure types not analyzed in prior studies. Second, forecasts are less informative than earnings announcements for our full sample, a finding that is inconsistent with earlier results in Pownall and Waymire (1989). Third, differences across forecast forms are not significant at conventional levels. Fourth, interim forecasts are significantly more informative than annual projections. This result is driven largely by maximum forecasts, which are highly informative and more frequent in the interim forecast subsample. We document several additional regularities that may be of interest to researchers. First, point and range annual forecasts comprise less than 20 percent of our sample. This suggests that the incidence of voluntary management forecast disclosure is possibly far greater than suggested by previous studies. Second, range forecasts tend to be quite inaccurate expost. Actual earnings per share (EPS) fell outside the forecasted bounds in more than 50 percent of our range forecasts. Third, forecasts that are more qualitative tend to be issued over longer horizons. Minimum forecasts are issued over the longest horizons for our sample, and interim point projections have the shortest horizons. Finally, extensions to our primary tests provide some evidence that maximum forecasts have significant negative price effects, and that for point forecasts, forecast revisions are highly informative.]

[The Internal Revenue Service (IRS) relies increasingly on its ability to detect taxpayer noncompliance without engaging in a comprehensive individual audit. The IRS's compliance initiative, Compliance 2000, emphasizes the targeting of noncompliant taxpayers rather than relying on random audits to enforce the tax laws. For example, the IRS uses a model developed from the Taxpayer Compliance Measurement Program (TCMP) to help it choose which returns to audit. The treatment of losses from tax shelter partnerships presents a difficult compliance problem for the IRS. It is not evident from the face of either the partnership return or the partner's return whether the losses from the partnership can be legitimately deducted. A plausible audit strategy is for the IRS to develop models that can predict when an individual is improperly deducting a loss. The tax shelter disclosure rules in I.R.C. section 6111 and section 6112 provide information to the IRS that helps it detect taxpayers investing in abusive tax shelters. Previous work has modeled tax compliance as a game between a wealth-maximizing taxpayer and a tax enforcement agency trying to maximize government revenues, net of audit costs (Graetz et al. 1986; Reinganum and Wilde 1986; Beck and Jung 1989). In these papers, the IRS uses the taxpayer's declaration of income when it decides whether to audit that taxpayer. The purpose of this paper is to examine the effect of information that helps the IRS predict tax evasion on the strategic choices made by the taxpayer and the IRS. The information has a direct effect by giving the IRS information that can improve its audit decision. It also has an indirect effect by changing the taxpayer's incentives to engage in tax evasion, which in turn changes the IRS's incentives to audit taxpayers. The optimal level of information acquisition is also examined. The analysis yields four important results regarding the effect of information on tax compliance. First, it can induce an increase in tax evasion. Second, it has no effect on the expected level of gross government revenues. Third, it can increase expected audit costs. Fourth, the optimal level of investment in information acquisition does not vary monotonically with tax rates, penalty rates, audit costs, or the amount of loss deducted by the taxpayer.]

[Positive theory hypothesizes that accounting-based debt covenants are important factors in accounting choices. According to Watts and Zimmerman's (1990) survey, this hypothesis has generally been supported by earlier studies. That is, the closer the firm is to violating accounting covenants, the more likely managers would choose income-increasing methods. Recently, research attention has shifted to the event of covenant violation itself. For example, Beneish and Press (1993) estimate debtors' costs of violations. Further, DeFond and Jiambalvo (1991) and Sweeney (1992) examine debtors' manipulative behavior before covenant violations. These latter studies find that violations of accounting covenants are costly to debtors, who generally try to manipulate accounting numbers to avoid or defer technical defaults. The present study also focuses on the event of violation, but from the perspective of creditors. It explains two aspects of creditors' decision process following covenant violations. First, we find that creditors react to actual violations in two distinct ways: they could either waive the violations or could demand certain conditions such as early payment, increase of interest rate, reduction of borrowing base, and so forth. Second, we also model creditors' decisions either to waive or to call the debt using the option-pricing framework. We hypothesize that the determinants of waiver decisions include the firm's bankruptcy probability and leverage ratio. Moreover, maturity, size, and security of the debt issue involved should also be important factors in the waiver decisions. Empirically, we find that creditors are more likely to grant a waiver to the firm with a lower estimated probability of bankruptcy and a lower leverage ratio. Further, debt issues that are secured or smaller in size are more likely to have violations waived than unsecured or larger issues. The maturity variable, however, is not found a significant determinant of the waiver decisions. Using the factors identified in this study, managers can assess the probability of receiving a waiver and prepare necessary strategies to ensure the firm's survival. Auditors also can use those factors to assess the possibility of the client's receiving a waiver of covenant violation as part of their evaluation of the firm's ability to continue as a going concern. Moreover, since debtors prefer waivers to nonwaivers, the prospect of receiving a waiver is likely to influence managerial behavior, including the choice of accounting alternatives. Managers expecting a nonwaiver from creditors would have more incentive to select accounting methods to avoid covenant violations.]

[One of the most common decisions facing an internal auditor is choosing which line items to investigate. An extensive literature (Dworin and Grimlund 1984; Leslie et al. 1980; Menzefricke 1984; Teitlebaum and Robinson 1975) deals with the statistical and decision-theoretic aspects of his choice. This paper expands on previous work by adding a strategic source of errors: dishonest employees. It addresses the question of how the presence of strategic errors affects the relationship between the auditor's testing strategy and item value. I show that incorporating strategic errors can lead to audit strategies similar to Physical Units and Dollar Units Sampling. I highlight the assumptions driving the results by contrasting a firm's (or internal auditor's) use of an optional test in four stylized models of accounts receivable. The first model examines the firm's behavior when faced with non-strategic (statistical) billing errors. In this model the accounting system generates random errors that result in over- or underbilling customers. The firm can use a costly, imperfect test to remove errors before the bills are sent out. In this nonstrategic model the firm randomizes and tests an item if and only if the benefit is greater than the cost. Because the amount of billing error is unrelated to the item value, there is no clear link between the firm's testing decision and the value of the line item. The second billing model adds the possible existence of dishonest employees who can steal from line items. A dishonest employee makes two decisions. He decides whether to steal from the line item, and, if he steals, he chooses the amount of the theft. A dishonest employee would steal the entire item if he were certain that the firm would never test that item. The dishonest employee's behavior forces the firm to consider the value of the item in determining the region of untested items. Specifically, low value items are never tested. As in many strategic models, the interaction with dishonest employees may lead to randomization. In particular, the randomized testing strategy can look like Stratified Physical Units Attributes Sampling (Leslie et al. 1980). The firm sorts items into different groups and each item in a group has the same probability of being tested. The third model contains only the statistical errors of incorrectly adding or deleting a sales discount, a percentage of the item value. Since the testing gain is directly related to the value of the line item, the firm's strategy depends on an item's value. The firm always tests high value items, and never tests low value items. The fourth model adds potentially dishonest employees who can provide unearned sales discounts to their confederates. In this model the firm stratifies items into three groups. It never investigates small items, always investigates large items, and randomizes over intermediate value items with probabilities roughly proportionate to the value of the item. This procedure is similar to a common audit procedure, Dollar Unit Cell Width Sampling (Leslie et al. 1980).]

[The goal of any cost management system is to provide relevant and timely information to management. This information supports better management of corporate resources in production of products or provision of services, and improves competitiveness in terms of costs, quality, and profitability. In this context, a cost management system can also be viewed as a planning and control management system (Berliner and Brimson 1988). Cooper (1988a, 1988b, 1989a, 1989b) provided a comprehensive discussion of activity-based costing (ABC), following the pioneering work of Kaplan (1983, 1984). Extension of ABC to the service industry was provided by Rotch (1990). ABC has also been extended into activity-based management (ABM) to include other considerations, such as customer profitability, manpower utilization, distribution channels, and other management issues. Thus, ABC is the information system that reveals the cost and profitability structure of products and services in an organization, while ABM describes the actions taken to improve quality and reduce costs and cycle time, once information about activities' costs is known. In this article, ABC is used as a generic concept without any loss of generality. An ABC system achieves improved accuracy in estimation of costs by using multiple cost drivers to trace the cost of activities to the products associated with the resources consumed by those activities. In this respect, a cost driver is an event, associated with an activity, that results in the consumption of firms' resources. Since the number of events performed in a firm is often vast, it may not be cost-effective to use a distinct and different cost driver for each activity. Thus, many activities may be grouped into a single driver to trace the costs of all the grouped activities for a product or service. For instance, each setup may be associated with a single cost driver that accounts for moving, grouping, sequencing, and segmenting. At the same time, there may be other competing cost drivers, such as setup hours, better correlated with the resources consumed by these grouped activities. In activity-based costing, these different cost drivers are not necessarily all proportional to unit volume, in contrast to traditional volume-based cost systems (Kaplan 1988, O'Guinn 1990, Dewan and Magee 1992). "The art of designing an ABC system can be viewed as making two separate but interrelated decisions about the number of cost drivers needed and which cost drivers to use. These decisions are interrelated because the type of cost drivers selected changes the number of drivers required to achieve a desired level of accuracy" (Cooper 1989a, 1989b). In this article, we provide an optimization model that balances savings in information processing costs with loss of accuracy. We show how to determine the number of drivers, and identify the representative cost drivers. The model is formulated as an integer program and is solved efficiently by using a composite greedy algorithm.]

[Recent research on cost driver analysis by Miller and Vollman (1985) and Cooper and Kaplan (1987) suggests that transactions deriving from the diversity of a firm's product line and the complexity of its production process, in addition to output volume, drive overhead costs. As a consequence, it is argued, conventional cost accounting systems based only on volume-related measures, such as units of output, direct labor hours, or machine hours, produce biased and materially misleading cost estimates for managerial decisions on price and product line (whether to continue or discontinue products, or to offer additional products). Systematic biases in cost estimates may also lead to distortions in flexible budgeting systems, variance analyses, and responsibility-accounting systems. Perhaps more important in the long run, omission of operations-based cost drivers may distort the investigation of the likely effects on costs of changes in operating strategies. Many firms have moved ahead on the basis of this perceived need for more accurate cost stimates and have designed and implemented activity-based costing systems (Schiff 1991). From an academic perspective, however, there is a need for further formal empirical research in this field. Cooper and Kaplan's (1987) evidence is based on field-study discussions with managers in a variety of manufacturing settings and experimentation with cost allocation and product-costing systems based on transactions. Foster and Gupta (1990) provide some of the first empirical evidence on the correlation of manufacturing overhead with output volume and operations-based measures that reflect characteristics of the manufacturing process. Using data obtained from 37 plants of a single manufacturing firm, Foster and Gupta found that most of the volume-related measures of output were highly correlated with manufacturing overhead (MOH), but because only a few measures of manufacturing complexity and efficiency were highly correlated with MOH, their findings leave the impression that systems based on just volume may not significantly distort information generated for managerial decision making. In contrast, we find empirical evidence in favor of incorporating operations-based cost drivers along with measures of volume in cost driver models. We draw upon previous work in cost accounting and economics to develop analogs in the airline industry for product diversity, production run volumes, and process complexity, and propose a framework for cost driver analysis in the U.S. airline industry. Using a panel of quarterly data for 1981-1985 compiled primarily from traffic and financial statistics submitted by carriers to the Civil Aeronautics Board (CAB) and Department of Transportation (DOT), we specify and estimate a multivariate system of cost functions with multiple cost drivers for the industry during the transition following deregulation. We find both volume- and operations-based cost drivers to be statistically significant. We also demonstrate the potential managerial importance of the operations-based drivers by explaining variations in marginal costs across airlines in terms of operating strategies reflected in the cost driver values. Empirical cost driver analysis is managerially significant for the industry and period that we examine. The proportion of indirect costs is large, and identification of input consumption for specific services is difficult. During the transition following deregulation, carriers adopted a rich variety of strategies to improve productivity, reduce costs, and increase market share. These strategies directly involved both volume- and operations-based cost drivers. The analytical framework and model that we have developed on the basis of prior literature concerned with the airline industry enable us to examine the differential cost effects of some of the most important strategies adopted.]