Knowledge that Transforms

[Libby (1993) suggests a simple model of the acquisition of expertise where knowledge and ability determine performance, and instruction, experience, and ability determine the acquisition of knowledge. An important implication of the model is that a detailed understanding of the knowledge acquisition process is needed before the practical implications of expertise research are evident (see also Bonner and Pennington 1991; Waller and Felix 1984). Libby's review indicates, however, that the vast majority of studies of the knowledge acquisition process focus on what knowledge auditors acquire during a particular period of time with the firm, but not on what particular aspects of instruction and experience lead to superior knowledge.1 The latter type of study is necessary before firms can determine how best to organize auditors' training and experiences to allow efficient and effective acquisition of the necessary knowledge. The importance of analytical procedures in auditing and the popularity of ratio analysis as an analytical procedure are well-documented (e.g., Biggs and Wild 1984; Libby 1985). The current study focuses on the knowledge necessary to perform ratio analysis in audit planning. Specifically, we examine the effectiveness of various combinations of instruction and experience (practice and feedback) in producing this knowledge. The results indicate that combinations of instruction and no experience or of instruction and practice without feedback do not produce knowledge. Practice with explanatory feedback and any form of instruction creates gains in knowledge, but may not always be available in the audit environment. Practice with outcome feedback, on the other hand, does not assist in the acquisition of knowledge unless it is preceded by instruction with what we have labeled "understanding rules," making this combination appear to be an adequate substitute for explanatory feedback. Practice with outcome feedback combined with what we call "how-to rules" does not promote knowledge acquisition. Finally, results indicate that ability aids in the acquisition of knowledge, and that this knowledge is related to performance in ratio analysis. These findings have implications for audit effectiveness and efficiency, and for education and firm training related to ratio analysis. If explanatory feedback can be replaced by a combination of understanding rules and practice with outcome feedback, audit efficiency could be increased since explanatory feedback takes more time and more experienced personnel. Explanatory feedback may also be inaccurate or unavailable, particularly under conditions of time pressure. However, if only outcome feedback is to be provided for ratio analysis, understanding rules must be incorporated into education and training. For the most part, firm training and university education currently provide only how-to rules for ratio analysis (see Bonner and Pennington 1991; Ernst & Whinney 1986). The ideas described above could also be extended to tasks other than ratio analysis for which outcome feedback is available (Solomon and Shields 1993).]

[In the usual agency analysis of moral hazard, the principal is endowed with a production process and must hire an agent to manage it. Output depends on the agent's effort, the production process supplied by the principal, and some random state realization. A common assumption is that the output of the production process is costlessly observable and sufficiently informative about the agent's effort to warrant using it for contracting. However, this assumption may not be descriptive of a large number of settings. In fact, it is hard to conceive of many production settings in which the gathering and reporting of any information is totally free and independent of costly design decisions. For example, if the agent produces some product, it is not costless to monitor the number or the quality of the units produced; someone must be paid or a machine must be purchased to do so. In addition, some opportunity cost may have to be incurred to rearrange the production process to facilitate the assessment of the agent's work. In this article, we consider the implications of relaxing the assumption that output is costlessly observable and contractible, by analyzing the optimal design of a costly unconditional monitoring system. We characterize the monitoring system in terms of the Type I error associated with the obedient action and the Type II errors associated with the disobedient actions. We find that it is always optimal to design the monitoring system such that the Type I error is smaller than the Type II error for any disobedient action. Further, we find that as the costliness of the monitoring system increases, the Type I error increases monotonically, while the Type II error initially decreases and then increases.]

[Understanding managers' incentives to disclose information voluntarily has been described as "the quintessential accounting problem" (Verrecchia 1990a, 245). In contrast to economic consequences (positive) theories, Leftwich (1990, 41) states that "there are few empirical investigations of the effect of an information role on accounting choice" and that "information economics has yet to yield a set of empirically testable propositions." This study addresses this empirical deficiency by testing hypotheses developed from two disclosure theories by examining Canadian firms' voluntary disclosure of defined benefit pension plan (DBPP) information. First, Verrecchia's (1983) proprietary cost theory states that the incentive to disclose information is a decreasing function of the potential proprietary costs attached to a disclosure and an increasing function of the favorableness of the news in a disclosure. Second, Diamond (1985) explains firms' voluntary disclosures through information cost savings. He shows that if a firm commits to a policy of disclosing relevant information, it will preempt investors' private information search activity. This provides a pareto improvement through lower overall information production costs. This study demonstrates the proprietary cost implications and valuation relevance of pension disclosures and then develops hypotheses and empirical surrogates for proprietary costs and private information acquisition cost savings in this setting. The results are consistent with the proprietary cost theory but are equivocal with respect to the information cost savings hypothesis. Proprietary costs mitigate the adverse selection argument in favor of full disclosure; moreover, the disclosures are conditioned on the favorableness of the news. Proxies representing proprietary costs related to labor are negatively associated with firms' DBPP disclosures.]