Knowledge that Transforms

In this paper I show that the aggregation of operating and financial income imposes three conditions on earnings‐based value functions. These three conditions provide a shortcut way to identify dividend irrelevant value functions. For example, consider any value function V t of book value b t , earnings x t , and dividends d t . The aggregation conditions imply that V t must be of the form V t = (1 − k)bt + k [f xt − dt]. f is the permanent earnings capitalization factor and undetermined weight k may be any function of Δ t ≡[φx t − d t ] − b t . The Ohlson 1995 model is the special case when k is constant. But generally k does not have to be constant to maintain dividend irrelevancy. Whenk varies with Δ t , V t is nonlinear in earnings. Hence, this result specifies how V t may be nonlinear in earnings in settings with limited liability or production or abandonment options and still be dividend‐irrelevant. An even more remarkable feature of this result is that it holds whether accounting is clean surplus or not. One must conclude that accounting‐based valuation properly builds from accounting aggregation and Δ t , and not from the clean surplus relation and abnormal earnings as many now believe.

The purpose of this study is to investigate whether and how shareholder‐level taxes affect earnings response coefficients (ERCs). Our tests indicate that when the tax rate on dividends increases, ERCs decrease for firms with high levels of dividend yield and whose marginal investor is likely to be an individual. For firms with high levels of share repurchase yield and whose marginal investor is likely to be an individual, an increase in dividend tax rate has no discernible effect on ERCs. These results are consistent with the notion that the tax penalty on dividends, relative to capital gains, reduces the earnings‐return relation.

In this paper, we consider the role of production externalities in the task assignment problem. Milgrom and Roberts (1992) suggest that complementarities available when agents are assigned to diverse tasks are necessary to overcome distortions in effort allocations caused by an inability to fine‐tune incentives when agents' compensation is based on aggregate imperfect signals. Our analysis formalizes this intuition in a setting that encompasses externalities under both diverse and similar task assignments.

We examine the influence of corporate taxes on U.S. firms' financing methods for taxable acquisitions of 100 percent of a target corporation's stock. We conduct tests of acquirer firms' use of debt or internal funds as the funding source for these acquisitions over the period 1987‐97. Our results provide the first empirical evidence that U.S. firms' use of debt to fund acquisitions significantly declines as foreign tax credit limitations reduce the marginal tax benefits received from borrowing. This finding is consistent with earlier speculation that U.S. foreign tax credit provisions could materially affect the capital costs of U.S. companies in debt‐financed acquisitions. We also find that these firms are generally high‐tax‐rate corporations whose financing choices are not significantly influenced by whether they acquire target‐firm tax loss carryovers. Our findings contribute to the accounting literature on the influence of taxes on the structure and financing of corporate acquisitions.

Under the 1996-98 security regulations in China, the accounting rate of return on equity (ROE) has to be greater than 10 percent for three "consecutive" years for a firm to qualify for stock rights offers. Despite declining economic conditions during this period, the percentage of firms reporting ROE between 10 and 11 percent is about "three" times that for 1994-95. This unique regulatory environment provides a natural experimental setting for the empirical assessment of earnings-management behavior and its consequences. This study examines whether listed Chinese firms manage earnings to meet regulatory benchmarks and whether regulators and investors consider the quality of earnings in their respective regulatory and investment decisions. On the basis of a sample of listed Chinese firms from 1996 to 1998, we observe that managers execute transactions involving below-the-line items and use income-increasing accounting accruals to meet regulatory ROE targets for stock rights offerings. The firms that apply for, but fail to receive, regulatory approval manage earnings more significantly than do firms that receive approval and pair-matched control firms. Our market study also suggests that investors differentiate the quality of earnings and put less value on earnings suspected of a greater degree of management. Overall, our results imply that the regulatory bodies and investors to some extent make rational adjustments for the quality of earnings.

The objective of this research is to articulate a decision‐making foundation for the systems audit approach. Under this audit approach, the auditor first gains an understanding of the auditee's economic environment, strategy, and business processes and then forms expectations about its performance and financial reporting. Proponents of this audit approach argue that decision making is enhanced because the knowledge of the system allows the auditor to focus on the most important risks. However, there has not been an explicit framework to explain how systems knowledge can enhance decision making. To provide such a framework, we combine mental model theory with general systems theory to produce a hypothesis we refer to as a systems‐mediated mental model hypothesis. We test this hypothesis using experimental economics methods. We find that (1) subjects make systematic errors under the setting without an organizing framework provided by the systems information, and (2) the presence of an organizing framework results in lower reporting errors. Importantly, the organizing framework significantly enhances decision making in the settings where the environment changed. Establishing a decision‐making foundation for systems audits can provide an important building block that, in part, can contribute to the development of a more effective and efficient audit technology ‐ an important objective now when audits are facing a credibility crisis.

We test the ability of analyst characteristics to explain relative forecast accuracy across legal origins (common law versus civil law). Common‐law countries generally have more effective corporate governance mechanisms, including stronger investor protection laws and inputs provided through higher‐quality financial reporting systems. In this type of environment, we predict that analysts with superior ability and resources in common‐law countries will more consistently outperform their peers because appropriate market‐based incentives exist. In civil‐law countries, where the demand for earnings information is reduced because of weaker corporate governance mechanisms and lower‐quality financial reporting, we predict that analysts with superior ability will less consistently provide superior forecasts. Results are consistent with our expectations and suggest an association between legal and financial reporting environments and analysts' forecast behavior.

Individuals who have their tax returns professionally prepared often overpay estimated income taxes, effectively giving the government an interest‐free loan. To understand why tax professionals may place their clients in positive prepayment positions, we draw on mental accounting theory. Mental accounting theory suggests that by placing taxpayers in positive prepayment positions, tax professionals induce a favorable mental representation of tax return preparation fees, perhaps allowing them to collect larger fractions of billable time and costs incurred on taxpayers' behalves. Thus, we hypothesize that tax return preparation fees are higher for taxpayers in positive prepayment positions than for taxpayers in negative prepayment positions. Regression results using tax return data for 68,736 taxpayers provide strong support for this hypothesis. To more fully understand the general nature of the relationship between taxpayers' prepayment positions and tax return preparation fees, we adapt the prospect theory value function to the tax domain and formulate three additional hypotheses. Consistent with theory, regression results indicate that the relation between taxpayers' prepayment positions and tax return preparation fees is (1) positive, (2) stronger for taxpayers who receive refunds that are less than fees than it is for taxpayers who receive refunds that are greater than fees, and (3) stronger for taxpayers in negative prepayment positions than for taxpayers in positive prepayment positions.

The traditional view that a corporation exists solely to serve the interests of the firm's shareholders has given way to a changing view that recognizes the importance of corporate constituents in addition to shareholders. Prior studies demonstrate a significant association between the sensitivity of CEO compensation and a firm's stock prices. However, the association between CEO compensation and the claim of other primary stakeholders (customers, employees, suppliers) has not been examined. The purpose of this study is to investigate whether the adoption of long‐term incentive plans aligns the interest of the CEO with the interest of the primary stakeholders in the firm. Using the fixed‐effect regression, our results indicate a significant association between the change in CEO compensation and the claims of the customers, shareholders, and employees. We contribute to the literature by demonstrating that the managers are accountable not only to the shareholders but also to primary stakeholders.

In this study, we incorporate taxpayers' threat /opportunity perceptions into our analysis of taxpayer behavior in order to refine and extend our understanding of the internal cognitive forces that shape taxpayer behavior. Decision‐making frames (that is, the gain and loss domains from the prospect theory value function) and individual perceptions (that is, perceptions of decision alternatives as being threats or opportunities) are both likely to influence behavior, yet prior research has generally ignored the behavioral effects of individual perceptions. The results of our experiment reveal that taxpayers who are due a tax refund (owe additional taxes) prior to considering a judgemental tax deduction tend to perceive the conservative (aggressive) tax deduction to be more of an opportunity/less of a threat. In turn, we find that taxpayer frames have a direct effect on taxpayer behavior and an indirect effect on behavior through their effect on taxpayers' threat/opportunity perceptions. Perhaps the most important message of this study is that researchers can advance our understanding of the internal cognitive processes that shape taxpayer behavior by incorporating taxpayer perceptions into their research designs.