Knowledge that Transforms

In the Sixties, the qualified stock option was the predominant form of long-term incentive compensation contract for major industrial firms in the U.S. In the early Seventies these same firms replaced their tax-qualified stock option plans with non-qualified sttock options and later modified these plans to include a variety of new contingent compensation arrangements, some of which were based on accounting numbers instead of stock prices. This paper develops the hypothesis that tax considerations play an important role in explaining the form of compensation contracts. The pattern and timing of changes in the compensation plans of the top 100 industrial firms provides evidence consistent with the tax hypothesis.

This paper presents evidence that petroleum firms whose financial statements were adversely affected by Statement of Accounting Standards No. 19 (SFAS-19) increased the rate at which they changed auditors during the full cost/successful efforts controversy. Firms relatively unaffected by SFAS-19 experienced no such increase in auditor change rates. While some important theoretical and empirical limitationns are encountered, the evidence is generally inconsistent with the accounting irrelevancy view that SFAS-19 had no economic consequences for petroleum firms. Auditor-client disagreement on this accounting standard appears to be an important determinant of the decision to change auditors. However, there is no observed tendency for firms to switch to auditors with whom they agree on petroleum accounting.

Procedural flexibility can have a substantial impact on reported costs, revenues, expenses, and balance sheet valuations. Until 1978 oil and gas companies had considerable flexibility in applying full cost and successful efforts. A unique opportunity to measure the income effect of firms' procedural choices occurred when the SEC specified the exact procedures that must be followed by oil and gas producers when they account for exploratory and development costs under both the full cost and successful efforts methods. In complying with the new rules firms were required to adjust retained earnings retroactively to reflect what it would have been if the new procedures had been in effect all along. These retained earnings adjustments provide a measure of the income effect of procedural choices. This study shows that economic incentives influence the procedural accounting choices which were made by oil and gas producers. The same economic incentives also influence the choice of full cost or successful efforts. Finally, the discriminatory ability of firms' economci incentives is most powerful when firms' reporting strategies are defined in terms of both choice of accounting methods and procedural applications within those methods.

This study tests Chicago Board Options Exchange efficiency by examining option price behavior in the weeks surrounding a firm's quarterly earnings announcement. The evidence presented here suggests that a first-order autoregressive seasonal process describes quarterly earnings behavior and demonstrates that the information content of an earnings announcement is fully incorporated in option prices by the end of the announcement week.

Abnormal returns (market model prediction errors) are the subject of many event studies in accounting and finance literature. Conditional on the event of interest, researchers have recently used cross-sectional regressions to examine relations between abnormal returns and firm specific variables. This paper demostrates that non-constant variences and covariances in market model residuals across firms introduced bias in the estimated slope coefficients of the independent variables, i.e., the expected signs of the estimated slope coefficients can be predicted a priori. A method is develope to removed the bias in the estimated slope coefficiets and is found to be effective. This method explicitly takes the dependence among abnormal returns across firms into account. Methods that assume abnormal returns across firms to be independent do not control for such bias.

The SEC currently requires that firms disclose recent disagreements with their auditors over accounting or auditing matters when a change in auditor is reported. The effectiveness and usefulness of requirements to disclose disagreements have been questioned, and previous empirical research on the issue has been inconclusive. This study investigates the information content of disclosure of the auditor-firm disagreements. The analysis indicates a significant negative market reaction in the week that the Form 8-K is filed with the SEC. This finding is consistent with the position that the disclosure provides information useful to investors.

A number of studies have tested for information content in the ASR 190 disclosure by comparing the conditional and unconditional distribution of abnormal security returns around the time of disclosure. Since no differences were observed, it was concluded that ASR 190 had no information content. The study reported below performs a similar test by estimating the regression function of the conditional distribution of abnormal returns. This test procedure controls for the information content in contemporaneous historical cost disclosure and uses a conditioning variable not considered in earlier tests. It finds statistically significant stock price effects. However, because most of the effects appear to precede the official announcement date by several months, it is unclear whether stock prices were responding to the leakage of the information content of ASR 190 prior to disclosure, to private production of information contained in ASR 190 or to a variable omitted from the study which happens to be correlated with replacement costs.

The specification of the market expectation of accounting numbers is a common feature of many empirical studies in accounting and finance. Givoly and Lakonishok (1979) found that financial analysts' forecasts have information content. This study evaluates the quality of analysts' forecasts as surrogates for the market expectation of earnings and compares it with that of prediction models commonly used in research. Results indicate that prediction errors of analysts are more closely associated with security price movements, suggesting that analysts' forecasts provide a better surrogate for market expectations than forecasts generated by time-series models. The study also identifies factors that might contribute to the performance of the financial analysts'forecasts. The broadness of the information set employed by analysts and, to a lesser extent, their reliance on information released after the end of the fiscal year appear to be important contributors to their performance.

This paper examines the relationship between the ownership control status of firms and the accounting methods they adopt. The arguments of Watts and Zimmerman's positive theory are integrated with those of managerial economists to generate the prediction that management controlled firms are more likely than owner controlled firms to adopt accounting methods which increase reported earnings. This prediction is inconsistent with Fama's hypothesis that the market for managerial talent will prevent management controlled firms from acting differently than owner controlled firms. This paper compares the depreciation methods used by a sample of management and owner controlled firms for financial reporting purposes. The comparison considers and controls for the factors of firm size, leverage, and the depreciation method used for tax reporting purposes. The comparison reveals that there is a significant difference in the depreciation methods adopted by management controlled and owner controlled firms for financial reporting purposes.

The study explores the incremental explanatory power of replacement cost earnings variables (derived from ASR 190 data) with respect to explaining cross sectional differences in security returns. As such, the study is a natural extension of previous research, including analyses of the effect of security returns of ASR 190 data at the time of disclosure, investigations of cross sectional relationships between security returns and historical cost earnings, and studies of multiple signals. The basic finding is that pre-holding gain net income provides no incremental explanatory powerm given knowledge of historical cost earnings. However, the converse does not hold. Taken together, the findings are consistent with the contention that pre-holding gain net income is a garbled version of historical cost earnings. The basic finding is robust under several extensions of the initial research design. The research design incorporates a two-stage approach which permits a determination of the incremental explanatory power of collinear variables. The findings are in contrast to those of a previous study by Easman et al. (1979). The nature of the difference in research design inducing the difference is identified. Potential reasons for the difference in findings are provided.