Knowledge that Transforms

Abstract Price controls 1 have a major impact on firms' earnings and cash flows. Because price control regulation is costly to firms, it is a type of regulatory intervention that can impact a firm's accounting decisions (Watts and Zimmerman, 1978). Thus, regulatory changes that give firms relief from price controls provide incentives for earnings management. This paper examines discretionary accruals made by New Zealand manufacturing firms in response to two sets of regulations issued in 1971 and 1972. These regulations allowed manufacturing firms to apply for price increases to gain relief from financial hardship caused by the 1970 Price Freeze Regulation. Using a modified accruals mode! that adjusts for price‐level movements, the paper tests discretionary accruals of two samples of manufacturing firms and one control sample of nonmanufacturing firms. The results provide evidence of income decreasing discretionary accruals by manufacturing firms for the years during which they could apply for price increases. The control firms do not exhibit significant discretionary accruals in 1971 or 1972. Also, this paper provides evidence that failing to adjust for price‐level movements in high inflationary periods could result in inferences of income decreasing discretionary accruals where none may exist.

Abstract We examine how financial analysts and equity investors incorporate information on deferred taxes from carryforwards into earnings forecasts and share prices. We focus on carryforwards because, in providing this information each period, management must use their private information about the firm's profitability prospects. Thus, accounting measurement of tax carryforwards is another way of providing a management earnings forecast. In analyzing the role of carryforwards in valuation, we distinguish between two conflicting effects. First, deferred taxes from carryforwards represent future tax savings; hence, they should be valued positively as assets. In contrast, the existence of tax carryforwards may signal a higher likelihood of future losses, which would have a negative effect on expected earnings and share prices. We find that analysts consider earnings of firms with carryforwards to be less persistent because of the increased likelihood of future losses. We also find that analysts tend to be less precise and more optimistic (biased) in forecasting earnings of firms with carryforwards. This higher optimism and lower precision are more pronounced just after firms adopt Statement of Financial Accounting Standards (SPAS) 109 and are almost entirely corrected over time. An analysis of investors' valuation indicates a strong positive relation between deferred taxes from carryforwards and share prices, suggesting that these carryforwards are valued as assets. Also, earnings and book values of equity are valued less in firms that have carryforwards than in firms without carryforwards. Finally, the valuation allowance required under SFAS 109 assists equity investors in valuing a firm's earnings and net assets. The combined findings on analysts' interpretation and investors' valuation suggest that analysts fail to fully capture the implication of carryforwards on future earnings within their forecasting horizon.

Abstract Building on the work of Bernard and Thomas 1990, we develop a model to infer the degree to which the information in an earnings announcement is incorporated into investors' expectations for the subsequent earnings announcement at any point in time between the two announcements. We are unable to reject the null hypothesis that investors' earnings expectations are based on a seasonal random walk and reflect none of the implications of the immediately prior earnings announcement up to 15 trading days after that announcement. By mid‐quarter, expectations are significantly more sophisticated than a seasonal random walk. Two trading days before the next earnings announcement, as much as one half of the information in the prior earnings announcement is reflected in earnings expectations. We also find that the dissemination of information, albeit predictable information, speeds the incorporation of prior earnings information into earnings expectations. Our results suggest that as information about future earnings that could have been discerned from the earlier announcements (because past earnings surprises predict future ones) is disseminated in a more transparent form, investors revise their earnings expectations to reflect this information. Thus, the investors' expectations appear to incorporate more and more of the serial correlation in earnings surprises as the quarter progresses, even though they do not consider per se the serial correlation in earnings surprises in forming their expectations.

Abstract This study examines whether client satisfaction can help explain cross‐sectional variation in Big 6 audit fees paid by Fortune 1000 clients. After controlling for other factors related to audit fees (including audit quality attributes), client satisfaction with the audit team is positively associated with fees. It appears that a dimension of client satisfaction unrelated to audit quality attributes is the factor associated with an audit fee premium. This dimension of satisfaction may reflect other aspects of service quality not documented in the literature, or it may simply enable an auditor to earn economic rents through enhanced bargaining power. Client satisfaction with the audit firm does not appear to be priced in this segment of the audit market. The results are consistent with the view that a Big 6 audit is a service that is differentiable in the eyes of client management, and the results highlight the importance of the audit team composition in allowing a Big 6 audit firm to differentiate the audit product. Also, if auditors are earning local rents due to enhanced satisfaction levels, then a perfect competition model may not be appropriate for the audit services market.

Abstract This paper develops a simple, two‐period specialization model to analyze the effect of start‐up costs on auditing competition. Audit firms in the model make strategic specialization and pricing decisions. Through specialization, an audit firm achieves a comparative cost advantage over its competitors for all clients whose characteristics are closer to its area of specialization. This comparative cost advantage is further fortified by the presence of start‐up costs. As a result, each audit firm obtains some market power and is able to price‐discriminate across clients by offering “specialization‐and‐relationship‐specific” audit fee schedules. This paper demonstrates that the practice of “low‐balling” is a natural consequence of competition among audit firms. However, low‐balling occurs only in a certain market segment where audit firms compete fiercely. This paper also shows that a policy of banning low‐balling acts as a substitute for the commitment of the audit firms to partially collude their pricing policies and results in increased profits for audit firms and increased fees. However, it also results in audit firms choosing specializations in a more efficient way, thereby reducing total auditing costs.