Knowledge that Transforms

Abstract 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.

Abstract Although neoclassical economic theory predicts that fixed cost magnitude and fixed cost reporting format will not influence short‐term pricing decisions, these factors systematically affected pricing decisions in a duopoly experiment. Increasing fixed cost magnitude (a pure sunk cost in this study) across experimental conditions caused participants to first lower, then raise, competitive prices. Consistent with the psychological phenomenon of loss aversion, this change in pricing behavior reduced the frequency of reported losses. This study further reveals that the accounting format for reporting fixed costs influenced pricing behavior. Specifically, participants receiving capacity costing feedback reports established increasingly lower selling prices relative to the prices established by participants receiving contribution margin feedback reports. Given that a very simple cosmetic reporting manipulation produced increasingly significant competitive pricing differences in a market setting, this study provides evidence that functional fixation is not necessarily eliminated by market forces.

Abstract 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.

Abstract We investigate whether the financial riskiness of large U.S. audit firm clienteles varied with the changing audit litigation liability environment during the period 1975‐99. Partitioning the period of study into four distinct periods (a benchmark period (1975‐84), a period of increasing concerns about litigation liability (1985‐89), a period of lobbying for reform (1990‐94), and a post‐relief period (1995‐99)), we find some evidence of risk decreases during 1985‐89, strong evidence of risk decreases during 1990‐94, and strong evidence of risk increases during 1995‐99. However, we also find that over the period of our study, a time during which Big 6 market shares grew appreciably, the proportion of litigious‐industry clients in Big 6 client portfolios grew at about the same rate as the proportion of such clients in the population. Moreover, the Big 6 share of the financially riskiest clients in the economy did not grow as fast as the overall Big 6 market share. In sum, although our evidence is consistent with the hypothesis that the riskiness of Big 6 client portfolios responded to changes in the audit litigation liability environment, we find no systematic evidence of a "race to the bottom" or "bottom fishing" by these firms in a bid to increase their market shares.

Abstract This study conducts a local analysis of the relation between market structure and audit fees. The research question of interest to us is how audit fees are determined by each practicing local office, after taking into account the auditor's own position in a local market and the influence exerted by his or her clients. Appealing to the economic theories of monopoly and monopsony power, we hypothesize a positive audit fee‐concentration relation, and a negative audit fee‐client influence relation. Results indicate that auditor market concentration is positively associated with the non‐Big 6 audit fees but is unrelated to the Big 6 audit fees. Evidence is mixed concerning the client influence hypothesis. When this construct is proxied by the number of rival auditors operating within a geographic area centered on the municipality, the prediction of negative audit fee‐client influence relation is strongly supported for both groups of auditors. Results are much weaker using measures developed based on the relative importance of a municipal client to its auditor's audit portfolio. The issues addressed in this study are important at a time when the Canadian municipal sector is undergoing major changes because of municipal amalgamation, altering the underlying market structure for audit services and the bargaining position of a municipality vis‐Ã‐vis its auditor. More broadly speaking, our analysis implies that when assessing an auditor's report for signs of client pressure, the professional oversight bodies and regulatory authorities need to consider the relative, rather than the absolute, bargaining position of the client in question.

Abstract We provide evidence on the impact of tax incentives and financial constraints on corporate R&D expenditure decisions. We contribute to extant research by comparing R&D expenditures in the United States and Canada, thereby exploiting the differences in the two countries' R&D tax credit mechanisms and generally accepted accounting principles. The two tax incentive mechanism designs are consistent with differing views of the degree of financial constraints faced by firms in these economies. Our sample also allows us to explore the effects of capitalizing R&D on Canadian firms. Employing a matched design, we document relations between tax credit incentives and R&D spending consistent with both Canadian and U.S. public companies responding as though they are not financially constrained. We estimate that the Canadian credit system induces, on average, $1.30 of additional R&D spending per dollar of taxes forgone while the U.S. system induces, on average, $2.96 of additional spending. We also find that firms that capitalize R&D costs in Canada spend, on average, 18 percent more on R&D. Collectively, this evidence is important to the ongoing debates in both countries concerning the appropriate design of incentives for R&D and is consistent with the assumptions found in the U.S. tax credit system, but not those found in the Canadian system.

Abstract This paper examines the attempts by the North American accounting institutes to develop a new market in e‐commerce assurance based on their claims to professional expertise through the WebTrust project. Employing actor‐network theory in an in‐depth longitudinal field study, we investigate how WebTrust was originally developed and promoted as a seal of business‐to‐consumer assurance, which largely failed to generate support in the marketplace. Proponents were subsequently able to generate more interest in the eyes of managers of online organizations by reshaping WebTrust as a flexible set of principles and criteria for systems advice and business‐to‐business assurance. Our analysis suggests that attempts to expand the accounting profession's domain of expertise reflect a trial‐and‐error process where the outcome achieved may be far from the vision that motivated the institutes into undertaking the project in the first place. We further show that the initial network of support for such projects can be quite fragile and dynamic as various actors reposition themselves around the shifting meanings attributed to the project.

Abstract We examine whether and how managers use loan loss provisions to smooth income and to signal their private information about their banks' future prospects. Our paper highlights that the use of the loan loss provision to accomplish more than one objective gives rise to situation‐specific costs and benefits of manipulating the provision up or down. We hypothesize that relatively undervalued banks have greater incentives to signal their future prospects than fairly valued banks and that banks' incentives to smooth intensify as premanaged earnings deviate from norms. On the basis of these conjectures, we categorize sample banks into subgroups that are predicted to use loan loss provisions consistent with their situation‐specific incentives. This allows us to refine the research methods used in prior research to examine heterogeneous incentives. While we find evidence consistent with the use of loan loss provisions to smooth earnings, particularly when premanaged earnings are extreme, our evidence on signaling is less consistent. In particular, our signaling results depend on the introduction of an interaction term that has not been used in prior research. We also document that the intensity of smoothing (signaling) is not uniform across the sample. In addition to being a function of the incentive to smooth (signal), it also is a function of the incentive to signal (smooth).

Financial statements summarize a firm's fiscal position using only a limited number of accounts. Readers often interpret financial statements in conjunction with other information, some of which may be aggregated in a different way (or not at all). This paper exploits properties of the double‐entry accounting system to provide a systematic approach to reconciling diverse financial data. The key is the ability to represent the double‐entry system by network flows and, thereby, access well‐recognized network optimization techniques. Two specific uses are investigated: the reconciliation of audit evidence with management‐prepared financial statements, and the creation of transaction‐level financial ratios.