Knowledge that Transforms

[Auditors and regulators claim that low balling (when an auditor prices the initial audit below his or her costs) occurs in the audit market and impairs audit quality. This paper uses the experimental economics methodology to examine the economic rationale for such a practice and to test the hypothesis of low balling under different conditions of transaction costs. Assuming competitive markets, cost advantages are predicted to accrue to the incumbent auditor when transaction costs are positive. In this setting, auditors would low ball in the initial engagement, and would earn client-specific quasi-rents in subsequent engagements. Competition in the market ensures that the auditor earns from any particular client "zero" cumulative profits over time. That is, the loss incurred in the initial engagement exactly offsets the total profits earned in subsequent periods. The method of testing the low-balling hypothesis consists of six controlled laboratory market experiments. In these markets, numerous buyers and sellers form single-period contracts using a sealed-offer institution extending over a two-period trading year. Each market consists of 17 independently repeated two-period years. Two markets possess zero transaction costs, while the other four markets contain varying levels of positive transaction costs. The results are consistent with low-balling behavior and predictions. Low balling is not observed in markets with no transaction costs; i.e., sellers do not price below their costs. In this case, seller profits per year are zero and incumbent sellers are not retained by buyers in Period 2 of a trading year. In the positive transaction cost markets, low balling occurs (sellers set Period 1 prices below their costs) and incumbent sellers in Period 2 charge prices that earn them positive profits for the period. Period 2 (Period 1) prices are at (approaching) predicted levels. Seller profits for a two-period year are generally zero, implying that Period 1 losses are offset by Period 2 profits. Additionally, the incumbent seller is retained by buyers in the second period of a given trading year. Overall, the results of this study support low-balling behavior and suggest that positive transaction costs might be the cause. This study also establishes a framework that can be expanded to investigate other phenomena such as auditor quality.]

[Previous research suggests that certain benefits may derive from the method used to account for business combinations and may affect how bidding firms structure and classify corporate acquisitions. This paper investigates whether benefits derived from accounting method are reflected in bid premia for target firms. Three estimates of bid premia are examined in 95 stock-for-stock acquisitions, 59 accounted for as poolings, and 36 accounted for as purchases. Sampling restrictions, covariance analysis, and a nonparametric matched pair comparison control for potentially confounding variables identified from prior research on bid premia determinants. The results show an association between acquisition accounting method and bid premia for target firms.]

[In this study I reexamine the impact of merger accounting method by using a sample of tax-free mergers drawn from a different time period and using more refined cumulative average residual (CAR) methodology. As in the Hong et al. study, the purchase method sample exhibits significant positive CARs over the entire period, which appear to originate in the interval preceding the announcement. The pooling method sample does not generate any significant residuals or CARs. To identify variables for which merger accounting method may be proxying, covariance analysis is used to determine that variables omitted from the capital asset pricing model (CAPM) do not influence the abnormal returns. Furthermore, probit analysis is used to investigate potential indirect cash-flow effects such as managerial income manipulation. A positive relationship between leverage and income-reducing policies is observed. This suggests that firms with high financial risk (leverage) may prefer purchase accounting to reduce reported earnings and regulators' attention. Tax characteristics of the acquired firms (net operating loss and investment tax credit carryforwards) are also examined as they can result in indirect cash-flow effects, such as reduced postmerger corporate income taxes. The limited data available indicate that tax factors have little impact on the CARs. Finally, a variable representing the relative bargaining strengths of the merging firms is tested for association with accounting method used. A statistically significant relationship is observed, and two implications follow from this result: (1) acquiring firms in a strong bargaining position are more likely to use the purchase method, and (2) as the bargaining strength of the acquiring firm decreases, the consideration given to the target firm increases while the magnitude of the CARs decreases. The contributions of the study are as follows. First, the abnormal returns to tax-free purchase method mergers, first observed by Hong et al., are found to persist and appear to originate during the preannouncement period. Second, other CAPM-omitted variables do not appear to influence these results. Finally, two tests of the association between potential indirect cash-flow effects and the CARs are significant and provide a partial explanation for the observed abnormal returns.]

[Studies in psychology have reported that subjects tend to overestimate the likelihood of a hypothesized cause because they do not generate or consider an adequate set of alternative explanations. These findings have been reported in non-auditing domains. This study investigates the effect of alternative explanations on experienced auditors' analytical review judgments. In this article, I view analytical review as a diagnostic process that involves the generation and evaluation of hypothesized causes of unusual fluctuations in financial statement relations. In this diagnostic process, hypothesized causes are used to direct auditors' search for information. Auditors from two Big Eight accounting firms participated in two experiments conducted to examine whether making alternative explanations available to auditors reduces their initial assessments of the likelihood of a hypothesized cause. The effect of varying the number and strength of alternatives was also examined. The results of the first experiment show a decrease in the assessed likelihood of a hypothesized cause when alternative explanations are provided to auditors. Results of the second experiment show that varying the number of alternative explanations influenced the degree of reduction in such likelihood assessments, but varying the strength of alternatives had no effect. Overall, the results of this study could lead to improved audit efficiency and effectiveness.]

[This paper proposes that interactions in accounting and auditing can be viewed as a large negotiation system. We define negotiations broadly to include any context in which two or more parties with differing preferences jointly make decisions that affect the welfare of both (all) parties. After a brief overview of negotiation research, the paper: (1) shows how recent research in accounting and auditing has implicitly addressed various aspects of negotiations; (2) comments on the Elias (1990) and Chalos and Haka (1990) studies which appear in this issue; (3) discusses departures from decision maker rationality which may seriously affect negotiations; and (4) uses three scenarios to highlight the importance of three negotiation issues (third party processes, the coordination of work groups, and social dilemmas) in accounting. We conclude by suggesting that a multifaceted research strategy, combining theory, description, and prescription, provides the greatest potential for progress in the study of accounting and auditing negotiations.]

[Williamson (1975) argues that firm organization is superior to open-market contracting due to the presence of an internal audit function that considers less formal evidence and explores byways not usually open to participants in open-market exchanges. This paper models the internal audit function as a scarce economic resource and the use of that resource for the provision of incentives. Information useful for incentives is assumed to be limited to verifiable information. The quantity of verifiable information produced by the internal audit function is constrained by either the time an internal auditor can spend verifying evidence or the time that employees have available to make such evidence verifiable (e.g., time spent with paperwork). The internal audit function is shown to produce near first-best solutions in a principal-agent model with simple and realistic policies that use only a small fraction of all available information. The attainment of such efficiency, however, depends on the level of management to which the internal auditors report. If independence is impaired, the firm may have to resort to other sources of contracting information, such as its financial reports. Because the information contained in financial reports is more limited than that provided by the internal audit function, first-best solutions may no longer be possible. Certain inadequacies of using financial reports as incentive devices may be mitigated by allowing the employee discretion over accounting alternatives. Such acts, however, may appear to outsiders to be income manipulations aimed solely at maximizing compensation.]

[This note examines the term "incremental information content," considers the most informative composition of income to include only components that are valued by investors, and determines the preferred level of disaggregation. The most common analysis in studies of incremental information content is to examine the coefficients from a regression of market-adjusted security returns for a 12-month period on the unexpected portion of two or more accounting income variables. A nonzero coefficient on one accounting variable is interpreted as evidence that the variable has information content that is "incremental" to the other variables in the equation. The accounting interpretation of this result in terms of the composition or disclosure of income depends on the other independent (conditioning) variables included in the estimated relation. Therefore, the interpretation of results beyond a statistical statement that one variable has information content incremental to another depends on the specification of the regression equation that is estimated. Results presented in two previous studies (Rayburn 1986; Bowen et al. 1987) are reviewed and extended from the perspective of the composition and disclosure of income. Taken together, the tests based on data reported in those two studies provide consistent and strong evidence that both cash flow and accrual components add to the informativeness of income. However data from Bowen et al. provide only weak evidence that current accrual and cash flow components of income are valued differently by investors, and similar tests based on Rayburn's data fail to reject the hypothesis that cash flows and current accruals are valued equivalently by the market. These results indicate that more research is needed on this issue.]