Knowledge that Transforms

[It is hypothesized that an inverse relation exists between the reputation of the auditor of an initial public offering and the initial return earned by an investor. Specifically, clients that hire more reputable CPA firms should exhibit lower initial returns than clients that choose to hire CPA firms with less reputation capital at stake. Two proxies for auditor reputation are used to test this hypothesis. The first reputation proxy uses indicator variables for auditor size. Results indicate that the widely used Big Eight/non-Big Eight classification may measure CPA firm reputation capital with error particularly for the smaller Big Eight and larger non-Big Eight firms. A second reputation proxy is developed by regressing compensation paid to the auditing firms on measures of marginal cost of performing the audit. The initial return to the IPO investors is regressed on the residual from the compensation regression to provide evidence of the reputation hypothesis. Results indicate that clients that pay a premium for their registration audit exhibit lower initial returns for their investors. Thus, the results of both tests provide support for the hypothesized inverse relation between auditor reputation and initial public offering initial return.]

[Financial reporting of lessors' transactions is a controversial area for several reasons: (1) lessors' accounting alternatives (e.g., operating vs. sales-type lease methods) usually generate large financial statement differences; (2) many of the parameters required to implement lessors' accounting choices (e.g., residual value estimates) are "soft" and, therefore, difficult to verify; (3) little is known about the sensitivity of income disclosures to errors in these parameter estimates; and (4) lessors' rules are still evolving and, therefore, are somewhat ill-defined. Using a highly critical Barron's article regarding Comdisco, Inc. as a starting point, this paper analyzes aspects of these reasons for controversy, especially (3) and (4). Specifically, Barron's argued that Comdisco's accounting for residual values and other leasing income recognition procedures were flawed. Using Comdisco's financial reports as a benchmark, we analyze elements of lessors' accounting and evaluate competing reporting options. We then examine the sensitivity of income numbers to residual value estimation errors using a simulation approach. The parameters for the simulation are derived from Comdisco's recent disclosures. The simulation results and analysis are used as a basis for recommending changes in lessors' financial disclosures and income determination.]

[This study examines the testable implications of two hypotheses for why firms undertook debt-equity swaps over the period August 1981-June 1984. The first hypothesis is that firms used the accounting-based reported earnings gain from the swap to smooth an unexpected and transitory decrease in their earnings per share. The second hypothesis is that a swap enabled the firm to relax potentially binding sinking-fund constraints in the cheapest feasible manner. Empirically, this study concludes that firms undertook debt-equity swaps for both reasons, but that swapping to smooth earnings was a much stronger motivation than swapping to relax potentially binding sinking-fund constraints.]

[Recent studies have considered the association between abnormal stock returns and forecast errors of various components of earnings. For discretionary outlays such as advertising or research and development (R&D), the sign and magnitude of the association between forecast errors and abnormal returns can provide information concerning the expected duration of benefits arising from these activities. This empirical study compares market reaction to advertising and R&D forecast errors with market reaction to forecast errors for conventional expenses, and with a theoretical benchmark for long-lived assets. The results are mixed, but on balance the evidence is consistent with a market assessment that advertising is short-lived while R&D is long-lived.]

[The degree to which earnings changes are thought to be permanent may determine the magnitude of the security price response to a given earnings announcement [Brown et al., 1985; Kormendi and Lipe, 1987; and Easton and Zmijewski, 1987]. This study extends this literature by examining the impact on stock prices of quarter ahead and year ahead forecast revisions, as well as forecast errors. Results indicate that analysts' forecast revisions provide significant incremental explanatory power in a pooled time-series, cross-sectional regression of abnormal returns on forecast errors and analyst forecast revisions. In addition, the fourth quarter announcement appears to provide more information to analysts and investors than interim announcements.]

[Auditors' reliance on their memories vis-�-vis their reliance on external information sources such as workpapers is of practical as well as research interest. This study examined auditors' relative confidence in relying on accurate and inaccurate recognitions of audit evidence. Each of 85 practicing auditors was asked to review a set of hypothetical audit workpapers, then after one day's delay, to respond to a recognition test and rate their confidence in their recognitions. They were asked to use the confidence rating to reflect their willingness to rely on their recognitions rather than on reviewing the workpapers or source documents again. Auditors were most confident in two cases: when they accurately recognized evidence that they had previously seen and when they confused their own inferences with actually observed evidence. Auditors are often as confident in their incomplete and inaccurate recognitions as they are in their accurate recognitions.]

[This paper reports the findings of a field study aimed at providing a better understanding of how and why managers of corporations with multiple divisions set the levels of achievability of annual profit center budget targets. The data, gathered from 54 profit centers in 12 corporations, show that most budget targets are set to be achievable an average of eight or nine years out of ten. This finding contrasts with the prescription made in most management accounting textbooks suggesting that for optimum motivation budget targets should be achievable less than 50 percent of the time. Managers maintain, however, that these highly achievable targets provide considerable challenge, and the high achievability actually provides many advantages, including improved corporate reporting, resource planning, control, and, combined with other control system elements, even motivation.]

[This paper tests two alternative hypotheses about why different firms choose different accounting measures of performance when determining executive compensation. The two measures of performance examined are accounting profits after income taxes and accounting profits before income taxes. Empirical evidence weakly suggests that the greater the degree to a firm is multinational, the more likely it is to use bonus plans that reward the manager on the basis of after-tax profits, as opposed to before-tax profits. The empirical evidence also suggests that the more capital intensive a firm is, the more likely it is to use bonus plans that reward the manager on the basis of after-tax profits.]

[Studies of the error-detection performance of audit procedures have found that three attention-directing procedures-client inquiry, expectations based on prior-year errors, and analytical review-signal almost half of the material errors detected. Further, the cost of performing such procedures appears to be relatively low, suggesting a positive cost/effectiveness relation. The primary purpose of the present study is to report detailed results of applying these attention-directing procedures when errors are identified. The sample consists of 186 engagements involving 368 proposed audit adjustments of a Big Eight audit firm. The results corroborate prior studies in that about half of the errors were signaled by the three attention-directing procedures and the simplest forms of these procedures (e.g., analytical reviews comparing current- and prior-year balances) identify many errors. Moreover, internal controls appear to condition the diagnosticity of audit procedures. When controls are strong, procedures involving internal accounting data are more diagnostic, while with weak controls evidence external to the accounting records signals relatively more errors.]

[This paper examines the comparative effect of information choice and information processing on the judgment performance of auditors over two different levels of environmental predictability. The task was the prediction of corporate failure. The study found that information choice, as evidenced through suboptimal selection of ratios, was a limiting factor in performance. However, although subjects were able to utilize all the information from the ratios they selected, they were unable to improve performance when supplied with the superior combination of ratios determined by the environmental model. Thus, information processing also became a limiting factor in performance when subjects were unable to choose their own ratios.]