Knowledge that Transforms

Executive stock options and convertible securities can increase the number of common shares outstanding while adding less than the market value of the newly issued securities to a firm's assets. We model the effect of expected dilution on the earnings/return relation. Expected dilution effectively reduces the permanence of an earnings innovation. Empirical evidence supports the hypothesis that dilutive securities attenuate the relation between earnings and returns. Estimated earnings response coefficients (ERCs) are significantly lower when there are shares reserved for conversion. The effect is more pronounced for firms that have experienced price increases or positive earnings news, as these increase the expected dilutive effect of conversions.

This study examines novice auditors' knowledge acquisition. I investigate whether low-cost, informal training interventions improve knowledge acquisition in complex auditing tasks. I designed an experiment that tests the effect of two alternative training approaches on audit judgment performance: explanatory feedback (a replication and extension of Bonner and Walker [1994]), and self-explanation of the rationale underlying a judgment of reasonableness. The results suggest that each approach promotes procedural knowledge acquisition, and combining the two approaches provides more benefit than either approach alone. The effectiveness of the self-explanation approach is primarily attributable to the learner's level of reasoning. Adding explanatory feedback to self-explanations has no incremental effect after controlling for the effect of the learner's reasoning. The paper discusses the implications of these results for the design of audit training environments.

We consider how auditors assess the risk of fraudulent financial reporting and plan their audit where a possibly fraudulent auditee anticipates the assessment and planning process. The auditor uses the auditee's (possibly fraudulent) earnings report to revise his beliefs about the likelihood of fraud when formulating an audit plan. We find that as underlying earnings increase, a fraudulent auditee increases reported earnings. In turn, as the auditee's reported earnings increase, the auditor increases audit effort. We also find that the auditee (who knows the auditor will use the report for audit planning) selects reports that increase his own expected payoff, relative to reports he would select if the auditor did not observe the report before finalizing the audit plan. By contrast, the auditor is no better off using the auditee's report for audit planning. Inherent risk, detection risk, and overall audit risk can increase when the auditor uses the auditee's report. Thus, because of the dynamic interaction between the auditor and auditee, procedures that aid in assessing audit risk may not reduce that risk or result in more efficient audits.

This study reports the results of three experiments that examine how preferences for wealth and honesty affect managerial reporting. We find that subjects often sacrifice wealth to make honest or partially honest reports, and they generally do not lie more as the payoff to lying increases. We also find less honesty under a contract that provides a smaller share of the total surplus to the manager than under one that provides a larger share, suggesting that the extent of honesty may depend on how the surplus is divided between the manager and the firm. The optimal agency contract yields more firm profit than a contract that relies exclusively on honest reporting. However, a modified version of the optimal agency contract, which makes use of subjects' preferences for honest reporting, yields the highest firm profit. These results suggest that firms may be able to design more profitable employment contracts than those identified by conventional economic analysis.

This paper presents a model in which a firm's owner, an auditor, and outside investors strategically interact. The owner's investment in the quality of the firm's internal control system and the auditor's effort jointly affect the informativeness of the auditor's report on the firm's financial statements. If the auditor's legal liability to investors is large, then an efficiency loss arises because the owner underinvests in the internal control system and the auditor overinvests effort. On the other hand, if the liability is small, then an efficiency loss arises from the owner's overinvestment and the auditor's underinvestment. Regulators can improve allocative efficiency by changing the auditor's legal liability. However, in our model, it is impossible to completely eliminate the efficiency loss by changing the auditor's liability alone, because no damage award can induce both the owner and auditor to make socially optimal investments in the internal control system and audit effort. We also interpret recent changes in the regulatory environment in the context of our model.

Concern that earnings management erodes the quality of financial reporting has prompted the Securities and Exchange Commission to question the role of the external auditor. To help address that concern, this study examines the relation between earnings management and auditor litigation. While prior research on the relation between auditor litigation and total accruals has yielded inconclusive results, I find that the risk of auditor litigation is positively associated with a sharper measure of earnings management—abnormal accruals. Using a larger and more recent sample, this study provides evidence that the probability of auditor litigation increases as clients report more positive (income-increasing) abnormal accruals. This result holds in: (1) univariate analyses, (2) logit analyses that also control for auditor size, client importance to the auditor, length of the auditor-client relationship, client industry, client financial condition, client size, and client growth, and in (3) the subsample of lawsuits alleging wrongdoing in the more recent time period (1984–1998).

The Private Securities Litigation Reform Act (PSLRA) increases restrictions on private litigation for securities fraud. We examine stock price reactions on legislative-event-related days of firms in four high-litigation-risk industries. Two other studies on this issue, Spiess and Tkac (1997) (ST) and Johnson et al. (2000) (JKN), conclude that shareholders considered PSLRA beneficial. While we find largely similar daily abnormal returns for event-related days that they examine, we present evidence that the timing of multiple confounding events makes the interpretation of these daily returns ambiguous. Results from additional analyses beyond those conducted by ST and JKN (market price reversal tests, analysis of additional legislative-event-related days, cumulative abnormal returns over the legislative period, and analysis of other events affecting investors' ability to bring securities-related lawsuits), are largely inconsistent with their interpretation, suggesting instead that shareholders in the four high-litigation-risk industries react negatively on average to PSLRA's restrictions on their ability to bring securities-related lawsuits.

In this study, we investigate whether audit managers' assessment of the quality of work their subordinates perform is influenced by the managers' prior impressions of these subordinates, and whether managers whom the firm considers outstanding are less susceptible to such an effect. We conduct an experiment using actual audit senior-manager teams. Each senior and manager participating in the experiment has been classified by his or her firm as either outstanding or average. Each manager is paired with two audit seniors (one outstanding senior and one average senior), and each evaluates the memos written by his or her paired seniors. Managers evaluate the quality of the memos twice: (1) first, with the identities of the seniors indicated on the memos, and (2) later, when the seniors' identities are not explicitly revealed. Results show that average managers evaluate memos written by outstanding seniors more favorably than those written by average seniors when they know the identities of the memos' authors, but not when the identities of the seniors are not revealed. Outstanding managers do not appear susceptible to this effect.

Profits a tax-exempt organization earns from business activities that are not related to the organization's exempt purpose are subject to the unrelated business income tax (UBIT). This paper shows that when the taxable and tax-exempt activities are substitutes, taxable income exceeds the incremental pretax financial return from the unrelated business activity because the exempt organization cannot deduct the opportunity cost of lost exempt function revenues when computing UBIT. As a result, the exempt organization may: (1) reduce or eliminate its unrelated business activity, or (2) change the way it uses its assets for unrelated business purposes by licensing the use of its assets to an unrelated taxable organization in exchange for nontaxable royalties. The model shows that although UBIT may distort the way in which an exempt organization uses its assets, this distortion can increase social welfare.