Knowledge that Transforms

In this paper we seek to document errors that could affect studies of earnings management. The book income adjustment (BIA) of the alternative minimum tax (AMT) created apparently strong incentives to manage book income downward in 1987. Five earlier papers using different methodologies and samples all conclude that earnings were reduced in response to the BIA. This consensus of findings offers an opportunity to investigate our speculation that methodological biases are more likely when there appear to be clear incentives for earnings management. A reexamination of these studies uncovers potential biases related to a variety of factors, including choices of scaling variables, selection of affected and control samples, and measurement error in estimated discretionary accruals. A reexamination of the argument underlying these studies also suggests that the incentives to manage earnings are less powerful than initially predicted, and are partially mitigated by tax and non‐tax factors. As a result, we believe that the extent of earnings management that occurred in 1987 in response to the BIA remains an unresolved issue.

Ideally, firms should jointly solve capacity‐planning and product‐pricing problems. In practice, informational limitations and cognitive bounds may force firms to sequentially solve the two problems. For example, a firm may plan capacity using limited demand information, and update prices subsequently once additional demand information becomes available. In a simple setting, we characterize the economic loss due to such sequential planning. We use simulation experiments to assess the extent of this loss in more complex settings. We find a relatively low loss if the firm plans for capacity using limited demand information and subsequently adjusts product prices to reflect realized market conditions. However, even “reasonable” restrictions on the subsequent price adjustment (e.g., constraining adjusted prices to always exceed full cost) lead to significant economic loss.

In this paper, we propose that affective reactions are integral to accounting decision contexts like capital budgeting, and that researchers must jointly consider affect and cognition to better understand accounting decision makers' behavior. We argue that interpersonal relationships are characteristic of many capital-budgeting contexts, and that these relationships can lead to emotional affective reactions. For example, reactions such as frustration and anger may result if a manager is treated unfairly by another individual involved in a capital project. Drawing on relevant work in neurobiology and psychology, we then predict that these affective reactions can influence managers' capital-budgeting decisions. We report on four experimental scenarios that demonstrate the impact of affective reactions on capital-budgeting decisions. Consistent with our predictions, the results indicate that managers consider both financial data and affective reactions when evaluating the utility of an investment alternative. Our results suggest that researchers should consider both affect and cognition to more fully understand decision making in accounting contexts.

This paper examines the effects of disclosure and recognition requirements on investment decisions when shareholders have limited liability. Firms' investment projects have either high initial pollution prevention costs or high subsequent clean-up costs, and their liability for clean-up costs may be either individual or joint and several. Even with individual liability for clean-up costs, shareholders' limited liability creates an incentive to select the latter project type and to impose costs on the rest of the economy. This tendency is exacerbated when clean-up liability is joint and several. We show that a disclosure requirement cannot have an unambiguous effect on the selection of the “cleaner” project. However, an accrual requirement, together with an accounting-based dividend restriction, is shown to promote choice of the project that imposes lower expected costs on the rest of the economy. Moreover, we find that it is possible for a recognition requirement to have a greater impact in a joint-and-several liability regime than in an individual liability regime.

Auditors' professional judgements are typically made following a discussion of contentious issues with other auditors (Gibbins and Mason 1988). These discussions may be with others at various levels in the hierarchy of the audit firm, with informal discussion with peers often taking place prior to formal discussions with audit supervisors (see, e.g., Solomon 1987). This study uses an experiment, involving 286 public accountants, to consider how discussion with peers may influence auditors' subsequent resolution of realistic audit‐specific moral dilemmas. Auditors were asked to prescriptively discuss how an accountant ideally should resolve a moral dilemma, or to deliberatively discuss how an accountant actually would resolve a moral dilemma. The results showed that auditors have higher moral reasoning scores after prescriptive discussion with peers and lower moral reasoning scores after deliberative discussion with peers. Thus, the study findings point to the significance of discussion of contentious dilemmas with peers and the importance of type of discussion for predicting and explaining auditors' moral reasoning. More specifically, the results indicate that discussion with peers may provide information and/or signal what is important and acceptable to the resolution of a moral dilemma, which facilitates transformation of an auditor's moral reasoning. This suggests the importance of informal mechanisms, such as peer discussion, as part of the social control system in audit firms.

While professional standards indicate that auditors have the responsibility to both detect and report material errors, empirical evidence shows that auditors waive approximately 50 percent of material errors (Wright and Wright 1997). Unlike prior research that has examined factors that may affect auditors' decisions to waive single material misstatements, the current study examines auditors' propensity to waive proposed adjusting journal entries (henceforth PAJEs) that exceed materiality, either individually or in aggregate, under several different aggregation contexts. These contexts are represented in the form of different cases that vary in terms of the materiality and income direction of the individual and aggregate PAJEs. The current paper posits that auditors will be more likely to waive PAJEs in excess of materiality (i.e., make a “non-GAAS” decision) when there is potential reward for doing so or when there is little litigation risk from doing so. The case decisions of 155 audit partners and managers indicate that they are not affected by potential reward (Client's Relative Fees), but are affected by potential risk (the Client's Financial Health, the PAJE's Subjectivity, and the PAJEs' Aggregate Directional Effect on Income). However, these factors are not equally influential across all aggregation contexts. Additionally, auditors are more likely to make non-GAAS decisions when they are evaluating immaterial PAJEs that aggregate to a material level than when they are evaluating a single material PAJE.

This paper reports the results of an experiment that investigates how external audit planning is affected when internal auditors have incentives and the opportunity to bias their evaluations. Specifically, we draw on attribution theory to examine how internal auditor eligibility for incentive compensation and participation in consulting (i.e., two factors that provide incentives to bias audit evaluations) affect external audit planning. In addition, we examine the effects of incentive compensation and a consulting role across two routine internal audit tasks — an objective tests of controls task and a subjective inventory valuation task — to evaluate whether their effects are contingent upon task subjectivity (i.e., opportunity to bias audit evaluations). Seventy‐six external auditors from four Big 5 public accounting firms participated in an experiment that manipulated internal auditor compensation (fixed salary versus incentive compensation), the type of work that the internal auditors routinely perform (primarily auditing versus primarily consulting), and audit task subjectivity (objective tests of controls versus subjective inventory valuation). Our results suggest that the nature of internal auditors' compensation and work affect audit planning recommendations differently. The opportunity to receive incentive compensation results in less reliance on internal auditors' work and greater budgeted audit hours, but only for the subjective task. Although a consulting role decreases perceived internal auditor objectivity, it has a limited effect on planning recommendations. Specifically, consulting has no effect on reliance, and leads to greater budgeted audit hours only when incentive compensation is available. We discuss potential explanations for the results as well as implications for audit research, practice, and regulation.