Knowledge that Transforms

The management accounting and operations management literatures argue that the adoption of advanced manufacturing practices, such as just‐in‐time (JIT), necessitates complementary changes in a firm's management accounting and control systems. This study uses a sample of JIT and non‐JIT plants operating in the Canadian automotive parts manufacturing industry to study the interaction among performance outcomes, intensity of JIT practices, and productivity measurement. This study provides evidence that productivity measurement mediates the relationship between performance outcomes and intensity of JIT practices. Specifically, both JIT and non‐JIT plants that use a broader range of productivity measures are more efficient and profitable than other plants. Also, plants that employ industry‐driven productivity measures are more profitable and efficient than plants that employ idiosyncratic productivity measures, especially if the former are more JIT‐intensive than the latter. Furthermore, plants that employ quality productivity measures are less efficient and less profitable than those that do not, especially if they use more intensive JIT practices. The latter result is consistent with JIT‐intensive plants overinvesting in quality. This study also finds that plants that invest more in buffer stock are less efficient and less profitable, especially if they use more intensive JIT practices. Despite the fact that plant profitability and efficiency are highly correlated, JIT‐intensive plants are more profitable but less efficient than plants that are not JIT‐intensive, after controlling for productivity measures, plant size, and buffer stock. This result suggests that despite wasting resources, JIT‐intensive plants are still able to generate relatively higher profits than plants that are not JIT‐intensive.

This paper investigates how external auditor provision of significant nonaudit services and client pressure to use the work of internal audit influence external auditors' use of internal auditors' work. More specifically, we study how external audit evidence gathering choices are influenced by nonaudit fees and client pressure. Our research is motivated by an observation that the magnitude of nonaudit services provided to audit clients introduces the risk that client management may leverage its position with the external auditor and potentially affect the audit process. We address this issue by extending prior research and focusing on the importance of various explanatory variables, including nonaudit service revenues, client pressure, internal audit quality, and coordination, to the external auditor's decision to rely on the work of internal audit. We use data primarily obtained through surveys completed by internal and external auditors. The survey responses represent 74 separate audit engagements. Our findings reveal that when significant nonaudit services are not provided to a client, internal audit quality and the level of internal‐external auditor coordination positively affect auditors' internal audit reliance decisions. However, when the auditor provides significant nonaudit services to the client, internal audit quality and the extent of internal ‐ external auditor coordination do not significantly affect auditors' reliance decisions. Furthermore, when significant nonaudit services are provided, client pressure significantly increases the extent of internal audit reliance. Thus, external auditors appear to be more affected by client pressure and less concerned about internal audit quality and coordination when making internal audit reliance decisions at clients for whom significant nonaudit services are also provided.

We investigate whether firms identified as potentially responsible parties (PRPs) under the Comprehensive Environmental Response, Compensation, and Liability Act (more commonly known as Superfund) appear to manipulate earnings to minimize their exposure to Superfund clean‐up and transaction costs. We analyze the discretionary accrual behavior of 612 PRPs from 1981 to 1995 and increase the power of our tests by identifying those PRPs with the most incentive to manage earnings during PRP identification years. The results provide robust evidence consistent with the hypothesis that these PRPs use income‐reducing discretionary accruals during PRP identification years in an attempt to minimize Superfund clean‐up and transaction costs. We also consider whether PRPs' incentives to manage earnings change in response to a change in the EPA regulatory regime and find modest evidence consistent with our conjecture.

Much research over the last 30 years has provided evidence that individuals display accounting fixation; that is, their cognitive process does not appropriately adapt to cross‐sectional or temporal differences in an accounting method. This paper presents the results of a quasi‐experimental test of the hypothesis that cognitive adaptation to a change in accounting method is an ordinal interactive function of three person characteristics: relevant accounting knowledge, general problem‐solving ability, and intrinsic motivation to appropriately engage in the decision task. Based on a product‐pricing decision task in which participants are provided with product costs reported by two generally employed product‐costing methods (activity‐based costing [ABC] and volume‐based costing), the results show that the majority of participants did not change their cognitive behavior when there was a change in the costing method. Further, those participants who did adapt to the change in accounting method, and thus avoided accounting fixation, did so by debiasing costs reported by volume‐based costing but not by ABC. Finally, these adapters generally exhibited high values for all three of the person characteristics compared with those who did not adapt.

This study examines the effect of independence threats and litigation risk on auditors' evaluation of information and subsequent reporting choices. Using a Web‐based experiment, I tracked auditors' information gathering and evaluation leading to a going‐concern reporting decision. Specifically, 48 audit managers assessed client survival likelihood, gathered additional information, and suggested audit report choices. I found that auditors facing high independence threats (fear of losing the client) evaluated information as more indicative of a surviving client and were more likely to suggest an unmodified audit report, consistent with client preferences. In contrast, auditors facing high litigation risk evaluated information as more indicative of a failing client and were more likely to suggest a modified audit report. In addition, the association between risk and report choice was fully mediated by final information evaluation. This suggests that it is unlikely that different reporting choices resulted from a conscious choice bias, but rather that motivated reasoning during evidence evaluation plays a key role in the effect of risk in auditor decision making.

The finance literature identifies two agency problems between managers and outside shareholders. First, there is a divergence‐of‐interests problem as management ownership falls. Second, there is an offsetting entrenchment problem when management ownership increases within intermediate regions of ownership. Agency problems are mitigated through contracting, but contracts are often based on accounting numbers prepared by management. Because accounting numbers must be reliable for contracts to be enforced, agency theory predicts a demand for higher‐quality auditors when agency problems are more severe. However, extant studies find no significant or robust relation between management ownership and audit firm size. In contrast to extant research, this study samples unlisted companies rather than listed companies for two reasons. First, the monitoring value of auditing may be higher in unlisted companies because they are less vulnerable to takeover and they are required to disclose much less nonaccounting information to shareholders. Second, unlisted companies have greater variation in management ownership, which permits more powerful tests of the demand for auditing as ownership varies between 0 percent and 100 percent. Consistent with a divergence‐of‐interests effect, the association between management ownership and audit firm size is found to be significantly negative within low and high regions of management ownership. The association is flatter and slightly positive within intermediate regions of management ownership, suggesting the existence of an opposite entrenchment effect. The negative association and the nonlinearity is consistent with the finance literature and with the predictions of agency theory.

This paper explores the behavior of workers in an environment where it is efficient to engage in the mutual exchange of help. Experimental data show that output and workers' payoffs are greater under team‐based incentives than under individual incentives in an environment where coordination is difficult. However, when the environment is more conducive to coordination (that is, a setting where agents interact repeatedly), output and payoffs are greater under individual incentives. Manipulation of the amount of mutually observable information provides evidence that team‐based incentives, relative to individual incentives, create a more difficult coordination problem for workers and that cooperation requires a richer informational environment.

In this paper, we model earnings management as a consequence of the interaction among self‐interested economic agents ‐ namely, the managers, the shareholders, and the regulators. In our model, a manager controls a stochastic production technology and makes periodic accounting reports about his or her performance; an owner chooses a compensation contract to induce desirable managerial inputs and reporting choices by the manager; and a regulatory body selects and enforces accounting standards to achieve certain social objectives. We show that various economic trade‐offs give rise to endogenous earnings management. Specifically, the owner may reduce agency costs by designing a compensation contract that tolerates some earnings management because such a contract allocates the compensation risk more efficiently. The earnings‐management activity produces accounting reports that deviate from those prescribed by accounting standards. Given such reports, the valuation of the firm may be nonlinear and s‐shaped, thereby recognizing the manager's reporting incentives. We also explore policy implications, noting that (1) the regulator may find enforcing a zero‐tolerance policy ‐ no earnings management allowed ‐ economically undesirable; and (2) when selecting the optimal accounting standard, valuation concerns may conflict with stewardship concerns. We conclude that earnings management is better understood in a strategic context that involves various economic trade‐offs.

We use experimental markets to test the Datar, Feltham, and Hughes (DFH) 1991 model of entrepreneur choice of auditor and retained ownership in initial public offerings (IPOs). DFH predict that entrepreneurs use retained ownership to signal IPO value and substitute high‐quality auditors for retained ownership to signal value as the risk of the IPO increases. Given the mixed support for DFH from archival research, we conduct experimental markets that directly operationalize the model's decision variables, which permits a direct test of whether the model is descriptively valid. In addition, our market setting provides a strong test of this theory by including an alternative Nash equilibrium also present in field settings, one in which only auditor quality is used by entrepreneurs to signal IPO value. Our results suggest that DFH predict entrepreneur behavior in baseline markets where both computerized investors and auditors are programmed to price consistently with the DFH equilibrium. However, the DFH model does not describe behavior when “robot” investors are replaced with human investors in the market. The results suggest that entrepreneurs and investors strategically interact in a manner that leads them away from the DFH equilibrium and toward the alternative Nash equilibrium behavior of entrepreneurs with high‐value assets hiring high‐quality auditors irrespective of IPO risk. Our results imply that the DFH model has limited descriptive validity, document the importance of strategic behavior on market equilibrium formation, and suggest that the mixed results found in prior DFH‐based field studies may reflect the model's low descriptive validity.

Our study examines the circumstances of non‐GAAP financial reporting by 492 U.S. companies that announced restatements from 1995 to 1999. We focus on income statements to analyze the occurrence and resolution of litigation over restatements and explore the role of accounting items in bringing and resolving this litigation. We provide evidence on the pervasiveness of accounting misstatements, describe their nature, and show how, if at all, they affect litigation. We assess the nature of restatements by determining whether regular, recurring earnings from primary operations (core) or other components of earnings (noncore) are misstated, and we assess their pervasiveness by estimating the number of primary accounts misstated. In our sample, companies with core restatements have higher frequencies of intentional misstatements (fraud) and subsequent bankruptcy or delisting. Likewise, these companies have, on average, more material misstatements, more negative security price reactions to restatement announcements, and more negative security price changes over the six months preceding and following restatement announcements. However, controlling for these and other factors, we find a significant association between accounting items and litigation, whether occurrences or resolutions. Specifically, core restatements — driven primarily by misstatements of revenue, a component of core earnings — and more pervasive restatements each play a role, while misstatements of noncore earnings alone do not.