Knowledge that Transforms

[This article provides a link between two conflicting approaches to accounting theory. One approach focuses on "proper" income measurement or asset valuation. Under this approach, income is often viewed as economic income plus error, where the error arises from institutional constraints. The other approach focuses on information disclosure. According to this other approach, income is generally viewed as an informative random variable that assists in deriving, say, an economic valuation of the entity. The former approach tends to view the economic norm as a desideratum, thereby leaving the demand for accounting services outside of the formal theory. The latter approach tends to view the information content as a desideratum, thereby leaving most accounting structure outside of the formal theory. These two approaches are linked in this article by treating income measurement as a process by which useful information is conveyed, using the language of proper income measurement or asset valuation. Why this particular language is adopted is not addressed. Thus, the question of why one might select a particular measurement scale (e.g., Celsius) over some other scale (e.g., Fahrenheit) is not examined. Rather, the question asked is whether there is any loss of generality by confining the accounting system to income measurement techniques. The answer is no. The argument runs as follows. First, an exogenous stream of net cash flows and realizations of some (informative) random variable are postulated. Then, an accounting system is introduced. At periodic intervals, this system must compute the expected present value of the future net cash flows from (only) the realized net cash flow and random variable. The accounting system then reports the net cash flow and income (defined to be the sum of net cash flow and the change in expected present value) in each period. Finally, it is determined whether reporting net cash flows and income in this manner discloses fully the information contained in the original stream of net cash flows and realizations of the random variable. This may be the case. If not, a conservative accounting treatment can always be constructed that does disclose the information fully. Hence, the accounting apparatus, coupled with conservatism, provides the link between the two approaches to accounting theory. The information content of the accounting measure is ensured even when the measure is computed in a classical manner. A key feature of the argument is that "accounting value" and "economic value" may diverge. Paradoxically, this divergence may be essential to conveying the information. Therefore, it may not be correct to claim that inability to value particular resources or transactions is the important feature in defining the accounting domain.]

[Accounting numbers are frequently used for performance evaluation because they are typically the firm's main source of formal information. As a result, employees become concerned about accounting-based budgeting processes. Whether it would be economically valuable to allow an employee to become a participant in this process is determined by the link between accounting signals and the performance expected of that employee. This article shows that by dividing activities into those that directly influence accounting measurements and those that do not, certain aspects of this link can be modeled. The results of a principal-agent analysis indicate that, in some cases, participation designed to communicate the agent's private information has no economic value even though the principal is willing to pay nonzero amounts to observe that information. The result of zero value to participation is obtained because if the agent's compensation depends only on accounting data (e.g., product cost data), any information concerning indirectly related activities may have no motivational effect on the agent and, hence, would not be useful. Conversely, if the indirectly related activities are costly to the agent (i.e., if they cause disutility), it is useful for the principal to have access to this information to adjust the agent's compensation accordingly.]

[Previous studies concerning experience effects in audit judgments have produced mixed results, possibly because they did not consider the knowledge necessary to complete the task and when it would normally be acquired. Further, many studies did not view the global judgment process as consisting of several components, e.g., cue selection. Task-specific knowledge may aid the performance of experienced auditors more in some components than in others. Not considering task-specific knowledge or viewing the judgment process as being comprised of components may have led to certain problems in generalizing the results of these studies to other auditing tasks. Those problems are addressed in the design of this study, which examines experience effects, specifically the role of task-specific knowledge, in the cue selection and cue weighting components of two audit tasks, analytical risk assessment and control risk assessment. Results indicate that task-specific knowledge aided the performance of experienced auditors in both the cue selection and cue weighting components only in analytical risk assessment.]

[Previous researchers have identified the pricing phenomena of "low-balling" and "price-cutting" in the market for audit services. One branch of this research has empirically estimated the magnitude of these pricing phenomena, while the other has hypothesized that they are caused by transaction costs incurred when a client firm switches to a new auditor. A principal concern of those who oversee the market for audit services is that the same forces that produce low-balling and price-cutting give the incumbent auditor a positive expected payoff from retaining the client. Such an interest in the client (called the "value of incumbency") could reduce the auditor's independence from the client, thereby affecting the quality of financial reporting. In this article, a multiperiod model of the audit market for a single client is presented, with the introduction of a reporting issue over which the auditor and the client may disagree. For instance, the client may prefer not to recognize an estimated liability, while the incumbent auditor believes that not recognizing the liability could be regarded as an audit failure at some point in the future. Under the assumptions that contingent audit fees are not allowed and that auditors and clients cannot make binding multiperiod commitments, the research shows that the auditor's value of incumbency presents a threat to independence only under limited circumstances. One condition that must be fulfilled for the client to put pressure on the auditor is that auditors in the market must disagree among themselves as to the appropriateness of the reporting policy desired by the client. If all auditors agree that the reporting policy desired by the client could be regarded as an audit failure, then a positive value of incumbency should not cause an auditor to compromise his or her independence. Another condition identified is that the reporting issue must affect the client for more than one reporting period. Otherwise, the auditor's positive value of incumbency will not produce any incentives to compromise independence. In addition, a positive value of incumbency will not compromise independence on reporting issues that are regarded as very important by either the client or the auditor. One of the interesting results of the analysis is the identification of a link between auditor independence and the nature of financial reporting standards. Auditor independence is easier to maintain when financial reporting standards leave less room for disagreement among auditors regarding the proper application of those standards to client circumstances. Indeed, such "cut-and-dried" reporting standards may be preferred by accountants with an established client base and large values of incumbency. Finally, the research describes some of the difficulties in defining auditor independence in a market environment.]

[The choice of the appropriate actuarial cost method was an important issue considered at the different stages of the process that led to the promulgation of the SFAS No. 87, "Employers' Accounting for Pensions." Actuarial cost methods have been used by firms for accruing periodic pension expenses and determining the funding of defined-benefit pension plans. These methods have been classified by actuaries into cost-allocation methods and benefit-allocation methods. This study identifies and evaluates some possible determinants of the switch from a cost-allocation actuarial cost method to a benefit-allocation actuarial cost method. The primary effects of this switch are a decrease in pension expense and in the amount funded to the pension plan. The decreases in pension expense and funding arise because benefit-allocation methods have lower pension liabilities than do cost-allocation methods. This study hypothesizes that the primary reasons for the switch in actuarial cost methods are: a reduction in contracting costs, a decline in the taxpaying status and the earnings performance, and a preference for internal over external sources of funds for financing investment outlays. In addition, the study examines whether an actuarial alignment of pension assets to the reported present value of the accumulated plan benefits motivates the switch in actuarial cost methods and controls for the effect of differing interest rates in the computation of the accumulated plan benefits. The hypotheses are tested by comparing switch firms to industry-matched nonswitch firms and using proxy measures to operationalize the theoretical concepts. The comparisons are performed in the year prior to the switch, the year of the switch, and the year following the switch by relying on multivariate logit models. The primary advantage of logit models is the presence of consistent coefficient estimates whenever choice-based sampling is involved. Univariate matched-pairs t-tests and Wilcoxon sign-rank tests are also performed in the year of the switch. The empirical findings suggest that financial statement considerations and reduction in pension funding appear to be the primary reasons associated with the switch in actuarial cost methods. The reduction in pension funding is first accomplished by the use of higher interest rates, which decrease pension liabilities, and then by the switch into a benefit-allocation method, which provides an additional decrease in the pension liabilities. The last step is used if firms have limited freedom to make further increases in interest rates as unreasonably high interest rates are not permissible under ERISA. Empirical evidence based on multivariate logit models reveals a lower current assets to current liabilities ratio, a slower rate of investing into new projects, and a higher long-term debt to total tangible assets ratio for switch firms in comparison to their nonswitch counterparts for the year of the switch. To the extent that these relationships reflect a higher probability of technical default for switch firms, the findings are consistent with both the pension funding literature (Francis and Reiter 1987) and the accounting method choice literature (Holthausen and Leftwich 1983). In addition, this study points out the importance of an interactive effect between working capital ratio and rate of undertaking new investments in that increasing levels of working capital are needed to sustain higher rates of new investments.]

[In this article, we explore the ability of publicly available information to explain target firms' market "runups" prior to mergers and tender offers. Critics of the disclosure system argue that market runups before acquisition announcements indicate a failure of the disclosure system to guarantee equal access to information for all investors. However, the focus on acquisition announcement dates ignores that investors often have access to more timely sources of public information, including preliminary negotiation announcements, disclosures of the purchase of small blocks of stock, and published rumors. Thus, in assessing the market's use of non-public information, we concentrate on those runups that occur prior to the earliest possible public disclosure dates. Our emphasis on preliminary merger information parallels current legal and regulatory developments. Recent court decisions define preliminary merger negotiations as material information that is subject to Securities and Exchange Commission (SEC) disclosure laws. Also, the SEC now requires (with certain exemptions) the disclosure of preliminary merger negotiations in the Management Discussion and Analysis (MD&A) of forms 10-K and 10-Q. A second empirical question explored is whether market price movement prior to the release of merger information varies with firms' ownership structure (manager-controlled and owner-controlled firms). Since acquisitions often provide more attractive payoffs for owners as opposed to managers, ownership control structure may affect dissemination of firms' acquisition-related information. Therefore, we test whether presumed differences in target firms' information production are associated with distinct patterns of market runups. An event-type methodology is used for testing both questions. To test the event period, weekly residual returns are computed from CRSP for the period starting 20 weeks prior, and ending three weeks after, the first public disclosure date. For the 121 sample firms, the test statistics are based on the standardized average cumulative abnormal returns. Results indicate that substantial market activity occurs prior to what we could identify as the first public disclosure of any information about potential acquisition. This implies that such movements reflect nonpublic information or public information appearing in sources other than The Wall Street Journal and the Funk and Scott Index. We also found that market price runups occurred earlier for owner-controlled firms for both mergers and tender offers. The price runups were similar irrespective of whether the first public disclosure was definitive or hypothetical. Sensitivity tests indicate that the early price runups of owner-controlled firms are not explained by a few extreme values. The association between the timing of price runups and ownership structure reflects the expected differences in information production give firms' ownership control structure. This finding is consistent with the emphasis placed by the new auditing standards on firms' control environment including ownership structure.]

[The proliferation of control contests for large public corporations at 50%+ premiums above market illustrates the wide divergence between open-market stock prices and equity exchange values. This paper considers equity valuation in corporate control transactions-e.g., management buyouts and hostile takeovers-that engender potentially severe manager-stockholder conflicts. These conflicts generate a demand for independent assessments of equity values by investment bankers who specialize in these appraisals. The paper provides evidence from (1) a large sample of fairness opinions on management buyouts, and (2) a small sample of investment bankers' working papers which indicates that investment bankers' valuation techniques make extensive use of accounting data. This demand for accounting information in equity valuation is distinct from that previously recognized in the capital markets or contracting literatures.]

[Measurement errors may have reduced the usefulness of current-cost and replacement-cost data. Under the provisions of Accounting Series Release No. 190 (ASR 190), replacement-cost valuations of plant and equipment (and related depreciation) often include the cost of technological advances and often these advances would reduce operating costs below the level reported by historical cost. As a result, when replacement-cost depreciation is substituted for historical-cost depreciation, the cost of doing business includes the high capital cost of the advanced technology as well as the high operating costs of the older technology in use, which creates measurement errors. ASR 190 was criticized because the reported depreciation amounts are not suitable for calculating income. Although Statement of Financial Accounting Standards No. 33 (FAS 33) includes provisions to remedy this problem, they may not have been effective because relatively few firms have reduced related depreciation expense to adjust for the present value of operating-cost savings. Moreover, numerous firms have relied on price indexes, which are not known to fully reflect technological changes. Therefore, the question arises as to whether current-cost data have substantially less measurement errors than replacement cost-data as a result of ignoring the effects of technological change. Analysis of a sample of 75 firms that reported under both methods for 1979 shows that current-cost depreciation is substantially smaller than replacement-cost depreciation for most firms. This finding suggests the presence of a smaller measurement error from technological change in the current-cost data compared with replacement-cost data. Nevertheless, additional analyses indicate the existence of measurement error in current-cost data also. First, an error component is common to about 25 percent of the sample firms that reported almost identical depreciation amounts under current cost and replacement cost. Second, the excess of replacement-cost depreciation over current-cost depreciation is not in proportion with the amount of potential operating-cost savings described in narrative disclosures accompanying the replacement-cost data. If these narrative disclosures are accurate, this divergence suggests incomplete adjustments of current-cost data for this type of technological change. Third, potential tax incentives may have influenced the measurement of current cost. Voluntary disclosure of effective tax rates on a current-cost basis is associated with the choice of measurement method (greater use of indexation). Moreover, current-cost and replacement-cost depreciation are relatively more similar for firms disclosing effective tax rates than for nondisclosing firms (suggesting smaller adjustments for technological change in current-cost data, which results in higher current-cost tax rates).]

[This paper reviews and critiques the positive accounting literature following publication of Watts and Zimmerman (1978, 1979). The 1978 paper helped generate the positive accounting literature which offers an explanation of accounting practice, suggests the importance of contracting costs, and has led to the discovery of some previously unknown empirical regularities. The 1979 paper produced a methodological debate that has not been very productive. This paper attempts to remove some common misconceptions about methodology that surfaced in the debate. It also suggests ways to improve positive research in accounting choice. The most important of these improvements is tighter links between the theory and the empirical tests. A second suggested improvement is the development of models that recognize the endogeneity among the variables in the regressions. A third improvement is reduction in measurement errors in both the dependent and independent variables in the regressions.]

[Under current tax law the capital gains tax generally is due only when an appreciated capital asset is sold and may be avoided altogether at death. As a consequence, this tax rule is commonly believed to create a lock-in effect because it discourages investors from selling appreciated capital assets. It is also frequently contended that this lock-in effect deters investors from moving current investments with accrued gains into more productive and potentially riskier-return investments because such action would be subject to taxation. One criticism of the current capital gains tax, therefore, is that it may deter investors from undertaking new risky investment. This paper reports the results of a laboratory experiment designed to assess the impact of five different capital gains tax regimes on the lock-in effect and new risky investment decisions. The different tax regimes investigated in the paper are ones that tax capital gains (1) at ordinary rates when an asset is sold, (2) at preferential rates (via a capital gains deduction) when an asset is sold, (3) at ordinary rates plus interest on any deferred tax applicable when an asset is sold, (4) at ordinary rates when an asset appreciates in value, and (5) at ordinary rates when the proceeds from an asset sale are not reinvested. The experiment involved 64 experienced investors and a computerized task in which subjects were required to allocate points between a locked-in asset and a new risky asset for five independent investment games and one of two rate conditions. The different tax regimes were simulated in the games by varying the manner, rate, and timing of a management fee assessed on the subjects' capital gains. Differences in the portfolio allocations of the subjects were then compared for the five games and two rate conditions to assess the tax and risk-taking effects of the alternative regimes. The study hypothesized that as the tax consequence of selling an asset became more unfavorable, subjects would exhibit a greater lock-in effect and would allocate a decreasing proportion of their capital to the new risky asset. In general, the results support the hypothesized relation. Subjects realized significantly fewer capital gains and allocated a significantly smaller portion of their portfolio to the new risky asset when they were charged the equivalent of a capital gains tax at the time of an asset sale than when their gains were taxed under the regimes based on appreciation in asset value or reinvestment of sales proceeds. The effects of those regimes that assessed the capital gains tax at the time of an asset sale also were mitigated when the tax rate was either reduced by means of a capital gains deduction or increased to include an interest charge on any deferred tax.]