Knowledge that Transforms

[Decision makers refer to their long-term memory to test the implications of evidence about a current problem (Birnberg and Shields 1984; Libby 1989). Given this reliance on long-term memory, biases in retrieval of previously encountered information may be an important source of decision error (Libby 1989), and differences in such biases may be one explanation for differences in auditor judgment performance across experience levels. The present study adopts a schema-based framework to examine some differences in the knowledge structures and judgments of experienced and inexperienced auditors and the relationship between these knowledge structures and judgments. The study examines the recall of typical and atypical information by experienced and inexperienced auditors within the context of a going-concern situation and then relates this measure of memory to the inferences and predictive judgments made by these auditors. Three experiments were conducted. In experiment 1, auditors read a description of a company that the audit partner-in-charge had suggested may have a going-concern problem. The description consisted of items that are considered typical of a company with going-concern problems, atypical items, and filler items. After an intervening period with a distractor task, all subjects were given a recall test, were asked to infer the likelihood of certain previously unstated items being true, and to estimate the probability that the firm would fail within a year. The first of six main findings showed that experienced auditors recalled more atypical items than inexperienced auditors, but there were no differences in the number of typical items recalled. Second, experienced auditors recalled more atypical than typical items, whereas inexperienced auditors did not. Third, experienced auditors were more likely than inexperienced auditors to infer that previously unstated atypical items were true. Fourth, for both experienced and inexperienced auditors, the ratio of atypical to typical items recalled was positively correlated with the inferences made, and the inferences were negatively correlated with the predictive judgments. This last correlation was much higher for the experienced than for the inexperienced auditors. Fifth, there was no direct relationship between recall and predictive judgments. Sixth, clustering of recall on the basis of atypical/typical items was significantly higher for experienced than for inexperienced auditors and was significantly correlated with inferences for experienced auditors only. In experiments 2 and 3, we collected additional data to examine some validity threats related to the first experiment. In experiment 2, we examined the relationship between recall and judgments, using audit managers who had worked on at least one audit with going-concern as an issue. We found results similar to those of experiment 1. In experiment 3, experienced auditors performed the recall and predictive judgments without the intervening inferences task. This provided a more direct test of the relationship between recall and predictive judgments. Again, no relationship was found.]

[An important differentiating attribute of the audit product is believed to be the credibility that the auditor is perceived to bring to an audit engagement. This study uses the context of the initial public offering (IPO) to investigate auditor credibility. It is contended that information asymmetry problems lead to a demand for credible auditors in companies going public. Entrepreneurs have incentives to signal their knowledge of favorable future earnings by selecting reputable auditors. Since there is limited information available on firms going public, employing credible auditors can convey monitoring cost advantages as well. Investment bankers also have a preference for credible auditors since they rely on audited financial statements in certifying the value of the firm and determining whether to underwrite the offering. In the present study, we consider auditor credibility in IPOs from the perspective of the client and the investment banker. If there is an increased demand for auditor credibility at the time of the IPO, there should be a significant number of credibility-increasing auditor changes prior to the offering. Furhter, if the investment banker benefits from having a more credible auditor sign off on statements prepared by the client, this should be reflected in the investment banker's fee structure. The empirical analysis is performed on companies that went public in 1985 and 1986. Relatively few auditor changes are observed prior to the offering. However, among those companies making auditor changes, there is a clear preference for more credible auditors. Logistic regression analysis shows that companies with prestigious investment bankers are more likely to change away from local auditors to more credible CPAs. The type of underwriting arrangement employed is also significant, consistent with an investment banker preference for credible auditors. A regression analysis is conducted, using the 1985 and 1986 IPOs, modeling investment banker compensation as a function of several factors, including type of auditor employed by the issuing firm. In the case of "firm commitment" offerings, the auditor type is found to be significant. Clients seem to be charged a smaller investment banking fee if they are associated with Big Eight auditors. There is no apparent auditor effect in the case of "best efforts" offerings. The evidence generally supports the hypothesis that investment bankers and their clients have a preference for credible auditors for the IPO.]

[This paper investigates whether capital market investors, in assessing market values of R&D firms' equity, view R&D limited partnerships (LPs) as increasing both the assets and liabilities of the R&D firms. The contract terms between the R&D firm and the LP suggest interpreting the LP as a call option held by the R&D firm and using option pricing theory to estimate the asset (the present value of the LP-funded R&D project) and liability (the present value of the exercise price) components of the option. Estimates of the LP variables are derived from information provided in footnote disclosures by R&D firms. However, several important assumptions are necessary to derive these estimates because the footnote disclosures do not provide all the data necessary to calculate the option values. The estimates of the LP variables are included as explanatory variables in a cross-sectional market value regression model that is based on the balance sheet identity. Other variables included in the regression model are the assets, liabilities, and in-house expenditures on R&D reported by the R&D firms in their financial statements. The results are consistent with market participants capitalizing in-house R&D expenditures (though SFAS No. 2 (1974) requires R&D expenditures to be expensed as incurred), viewing the call option feature of the LP as relevant information in assessing the market value of the R&D firm, and utilizing the footnote disclosures to assess the option values. The results support the SEC and the FASB positions that require R&D firms with LPs to disclose to investors the existence of and the amount raised through the LP, but the results do not necessarily support the SEC and FASB positions that this disclosure should be made on the balance sheet. The problems I encountered in estimating the LP variables suggest that more detailed disclosures of the terms of the LP option would help investors to assess the market value of R&D firms. More generally, the results suggest that the FASB should pay particular attention to the types of required disclosures and not be so concerned with whether the disclosures should be on or off-balance sheet in their ongoing consideration of financial instruments and transactions.]

[The relation between changing expectations of earnings and changing security prices is a central issue in accounting and finance. In this article, I reexamine common stock returns surrounding earnings forecast revisions, using a large database of individual analyst forecasts, and provide new evidence on market expectations of revisions, on cross-sectional differences in price effects, and on the influence of confounding events. In summary, my findings are that revisions affect prices, but prices do not immediately assimilate the information. Price reaction is greater when the percentage change in forecast is in the top or bottom five percent of the distribution of all forecast revisions. This price effect is not simply due to an association between revisions and earnings, dividend, or stock-split announcements. Surprisingly, prices continue to drift in the direction of the revision for about six months after the revision. Another surprise is that price reaction does not incorporate some publicly available information. Stock returns immediately after individual analyst forecast revisions suggest that an analyst's current outstanding forecast is a better measure of the market expectations of the analyst's next forecast than an updated version (i.e., the analyst's current forecast updated for information revealed after the date of the current forecast but before the date of the next forecast). I use this curious price reaction result to create an aggressive trading strategy that predicts changes in outstanding forecasts, in other words, a strategy that predicts price reactions. The difference in abnormal returns between securities predicted to perform best and worst is more than 13 percent every six months. Changes in beta do not explain these abnormal returns.]