Knowledge that Transforms

Accounting research contains two distinct approaches to the interaction between accounting management and the independent auditor. Game theory suggests that the auditor's testing strategy will affect the manager's reporting strategy and that the two strategies form an equilibrium. The game‐theoretic approach views the auditor as active, in that the auditor acknowledges the effect that his or her testing strategy has on the manager's reporting. In contrast, in the decision‐theoretic approach, the auditor tests reports, but ignores the effect that such testing might have on the manager's reporting behavior. Essentially, the decision‐theoretic approach views the auditor as passive, taking the reporting strategy as given when designing tests. We use United Kingdom data to estimate both models and test their validity using nested hypothesis tests. Our results demonstrate that the active, game‐theoretic model better describes the auditor‐manager interaction. This is the first empirical validation of the game‐theoretic model using archival accounting data.

Manufacturing firms can manipulate income by producing in excess of the quantity needed to meet current period demand, thereby allocating part of current period fixed manufacturing overhead costs from cost of goods sold to inventory. Because it is subject to manipulation, the component of earnings due to producing in excess of sales may be of lower quality than the remaining component of earnings. We investigate this possibility using a regression of security returns on unexpected income and an estimate of the change in percent of production added to inventory ( CPAI ). An analytical model indicates that CPAI determines the “earnings surprise” subject to manipulation by overproducing. Assuming the market recognizes this, the coefficient on CPAI should be negative because this low quality component must be deducted from the total “good news” conveyed by the change in reported earnings. Alternatively, CPAI may convey good or bad news to the market that is unrelated to the manipulation of current period earnings. Firms may increase the percent of production added to inventory in anticipation of high levels of future sales. In this case, the estimated coefficient on CPAI should be positive. Or, if the increase in the percent of production added to inventory reflects anticipation of a strike or an unexpected downturn in current sales, the estimated coefficient should be negative. Cross‐sectional tests using a large sample of manufacturing firms indicate a significant positive relation between security returns and CPAI. This finding is consistent with market participants viewing CPAI as a leading indicator of firm performance. Although the results are most supportive of CPAI conveying good news, there is some evidence that CPAI is used by managers to smooth earnings and, for firms classified as smoothing earnings, there is weak evidence that the component of earnings related to CPAI is viewed by market participants to be of lower quality.

I examine how an internal auditor, called the firm, designs a control system for a strategic employee who conditions his thefts on the amount and types of controls. Society sets minimum testing amounts and fines for detected theft, whereas the firm determines the employee's wages and the amount of monitoring above the minimum. The results fall into three separate cases. When society's minimum testing standards and fines are sufficiently high, the employee never steals in any period. In this case, the firm performs the minimum amount of testing and pays the lowest feasible wage. In the remaining two cases, the testing standard and fines are too low to prevent theft by themselves. In these two cases the firm's control system determines whether there will be theft in the first period. I show that if the firm chooses to prevent all first‐period theft, then it uses only one type of control. She offers a wage premium and monitors the minimum amount. The wage premium substitutes for a tine large enough to prevent all theft. If the firm designs controls that do not prevent all theft, then the firm also uses only one control. In contrast to the no‐theft case, the firm pays the lowest feasible wage and monitors above the minimum. This choice reflects the increasing returns to scale of monitoring in preventing theft.

Regulators have recently cited concerns about the extent and quality of accounting consultation within accounting firms on difficult client accounting policy issues. In this paper we report the results of research that examines the role of accounting consultation units in public accounting firms. We describe the five largest accounting consultation units in Canada. The accounting consultation units are then examined through the lens of organizational memory theory. We find differences among the accounting consultation units in their ability to act as a source of organizational memory for their firms. These differences include the following: the amount of resources devoted to the consultation function, the structure of the units, the mandate received by the unit from the firm, and the availability and amount of documentation about previous consultations. These differences suggest that firms' accounting consultation units differ in their ability to provide technical accounting advice. This variability may affect the actual or perceived quality of such advice to both clients and external regulators. In addition, this paper introduces organizational memory theory to the accounting literature. This theoretical approach may be useful in expanding the bounds of behavioral auditing research beyond the current emphasis on the individual auditor.

This research re‐examines whether there are differences in the forecast accuracy of financial analysts through a comparison of their annual earnings per share forecasts. The comparison of analyst forecast accuracy is made on both an ex post (within sample) and an ex ante (out of sample) basis. Early examinations of this issue by Richards (1976), Brown and Rozeff (1980), O'Brien (1987), Coggin and Hunter (1989), O'Brien (1990), and Butler and Lang (1991) were ex post and suggest the absence of analysts who can provide relatively more accurate forecasts over multiple years. Contrary to the results of prior research and consistent with the belief in the popular press, we document that differences do exist in financial analysts' ex post forecast accuracy. We show that the previous studies failed to find differences in forecast accuracy due to inadequate (or no) control for differences in the recency of forecasts issued by the analysts. It has been well documented in the literature that forecast recency is positively related to forecast accuracy (Crichfield, Dyckman, and Lakonishok 1978; O'Brien 1988; Brown 1991). Thus, failure to control for forecast recency may reduce the power of tests, making it difficult to reject the null hypothesis of no differences in forecast accuracy even if they do exist. In our analysis, we control for the differences in recency of analysts' forecasts using two different approaches. First, we use an estimated generalized least squares estimation procedure that captures the recency‐induced effects in the residuals of the model. Second, we use a matched‐pair design whereby we measure the relative forecast accuracy of an analyst by comparing his/her forecast error to the forecast error of another randomly selected analyst making forecasts for the same firm in the same year on or around the same date. Using both approaches, we find that differential forecast accuracy does exist amongst analysts, especially in samples with minimum forecast horizons of five and 60 trading days. We show that these differences are not attributable to differences in the forecast issuance frequency of the financial analysts. In sum, after controlling for firm, year, forecast recency, and forecast issuance frequency of individual analysts, the analyst effect persists. To validate our findings, we examine whether the differences in the forecast accuracy of financial analysts persist in holdout periods. Analysts were assigned a “superior” (“inferior”) status for a firm‐year in the estimation sample using percentile rankings on the distribution of absolute forecast errors for that firm‐year. We use estimation samples of one‐ to four‐year duration, and consider two different definitions of analyst forecast superiority. Analysts were classified as firm‐specific “superior” if they maintained a “superior” status in every year of the estimation sample. Furthermore, they were classified as industry‐specific “superior” if they were deemed firm‐specific “superior” with respect to at least two firms and firm‐specific “inferior” with respect to no firm in that industry. Using either definition, we find that analysts classified as “superior” in estimation samples generally remain superior in holdout periods. In contrast, we find that analysts identified as “inferior” in estimation samples do not remain inferior in holdout periods. Our results suggest that some analysts' earnings forecasts should be weighted higher than others when formulating composite earnings expectations. This suggestion is predicated on the assumption that capital markets distinguish between analysts who are ex ante superior, and that they utilize this information when formulating stock prices. Our study provides an ex ante framework for identifying those analysts who appear to be superior. When constructing weighted forecasts, a one‐year estimation period should be used because we obtain the strongest results of persistence in this case.