Knowledge that Transforms

[A between-subjects experiment was used to examine the effects of a decision aid in the AICPA's Audit Sampling Audit Guide on the magnitude and variability of auditor sample size judgments. Audit seniors were given background case information for a hypothetical audit task and were randomly assigned to one of three experimental groups: (1) an intuitive judgment group, (2) a decision aid group who calculated sample sizes using the AICPA Guide formula, or (3) a group who provided only the formula parameters from which the researchers later computed implied sample sizes. It was hypothesized that the sample sizes of group 2 would be larger than those of group 1 (due to insensitivity to power considerations), and that the implied sample sizes for group 3 would exceed those of group 2 (due to a tendency for auditors to "work backwards" toward an intuitive sample size). Both of these hypotheses were supported by the data. However, a test for differences in variability indicated that the decision aid led to a greater degree of inconsistency in sample size judgments. Results were consistent over two levels of internal control.]

[This study describes an experiment that examines the effects of managers' perceptions of internal and external auditing on the potential commission of financial reporting irregularities. An earlier study by Uecker et al. (1981) examined the impact of auditor aggressiveness on auditee behavior. By introducing a no-audit condition into the experimental design, this study addresses the fundamental issue of whether the existence of internal and external auditing affects auditee behavior. The study also tests whether the deterrence effects of internal and external auditing are similar. Rather than directly eliciting responses from subjects, this experiment used the quantitative randomized response technique. This method is designed to assure subjects of anonymity and thereby obtain truthful responses to sensitive questions. A total of 264 subjects, the vast majority of whom were experienced managers, made decisions on three cases involving financial reporting issues. The first case, involving a potential write-off of a loan made to a key company officer, was virtually identical to that of Uecker et al. (1981). The second case involved a writedown of inventory to the lower of cost or market. The third case involved an accrual of an invoice for services rendered prior to closing the books. These cases varied several factors expected to impact on the effectiveness of auditing as a deterrent. The factors were: materiality, type of irregularity, perceived extent of GAAP violation, and incentives for misstating income. The decisions were made in a situation in which there was either no auditing at all, only internal auditing, or only external auditing. The results clearly supported internal and external auditing as deterrents to financial reporting irregularities when all of the following four conditions were present: material dollar amounts, irregularities involving asset overstatements, unambiguous GAAP violations, and less incentive for misstating income. However, the deterrent effects cannot be attributed to any one of the conditions. Also, the internal auditing effects were similar to those of external auditing.]

[The traditional functional fixation view states that investors are always unsophisticated and, therefore, fail to unscramble the true cash flow implications of accounting data. At the other extreme, the efficient market hypothesis states that investors are always sophisticated and very accurately unscramble the true cash flow implications of accounting data. This article proposes and tests a middle ground between these opposite views. The extended functional fixation view proposes that when responding to accounting data, sometimes a firm's stock price is set by a sophisticated marginal investor, and sometimes it is set by an unsophisticated marginal investor. The likelihood that the stock price will be set by the latter type is conjectured to be measured by the relative proportion of a firm's stock held by unsophisticated investors as a whole. The extended functional fixation view is tested by examining the stock price reaction to quarterly earnings announcements of firms that undertook debt-equity swaps. Swaps produced an immediate accounting gain that amounted to about 20 percent of earnings for the quarter in which the swap was undertaken. Because sophisticated investors would have seen this gain at the initial swap announcement, the efficient market view predicts that there will be no stock price reaction to the re-announcement of the gain as part of the swap quarter's earnings. However, the extended functional fixation view predicts that there will be a reaction to the re-announcement of the gain because unsophisticated investors would not have known about the gain until the earnings announcement, at which time they would have misinterpreted it as a real gain, rather as just a realization of a previously unrealized capital gain. The larger the likelihood that a swapping firm's stock price was set by unsophisticated investors, the larger the stock price reaction. Overall, the empirical evidence presented appears inconsistent with the efficient market view, but consistent with the extended functional fixation view.]

[Prior studies of the adoption of LIFO, SFAS No. 34, and APBO No. 18 document a significant positive association between security analysts' forecast errors and the current year earnings effect of changes in accounting method. Examination of a sample of largely unstudied and diverse accounting changes, using different sources of forecasts, allows evaluation of the pervasiveness and robustness of these earlier findings. Prior work is extended by considering a variety of voluntary and mandatory changes, the extent of prior disclosure of information regarding the change, the nature of forecast revisions during the year of the change, and by comparing the bias and dispersion of forecasts in change years to that in non-change years. Tests using a firm as its own control in a matched-pairs design control for industry and firm-specific factors. Consistent with prior work, the results of this study suggest that analysts do not fully revise their forecasts for the current year's earnings effect of changes in accounting method. A positive, but generally insignificant, association between forecast errors and the earnings effect of changes is reported. Both forecast errors and the dispersion of forecasts are greater in the year of an accounting change than in non-change years, particularly in the absence of prior information regarding the change. A significant negative association is reported between the revision in analysts' forecasts and the impact of an accounting change on income. This observed relation is consistent with managers adopting accounting changes with an income smoothing motivation.]

[In 1984, the U.S. Supreme Court ruled that the Internal Revenue Service (IRS) has the authority to summon the workpapers of independent auditors when those workpapers are relevant to the collection of taxes. The exercise of this authority may in some circumstances make the tax costs of corporate audit clients dependent on the disclosures they make to auditors regarding sensitive tax information. This is because such disclosures are documented in auditors' tax accrual workpapers. Many in the accounting profession have argued that clients would reduce disclosures of sensitive tax information to their auditors if the IRS were to routinely access audit workpapers and that this would lead to less accurate financial statements. Underlying this argument are assumptions about the relationships between a client's incentives to disclose tax information to an auditor, the diagnosticity of audit procedures that can serve as substitutes for client disclosures, and the quality of financial reporting. The purpose of this study is to obtain experimental evidence regarding these relations in a laboratory market experiment. A series of four laboratory markets was conducted, in which 32 under-graduates served as subjects. Each market consisted of eight participants, three "auditors" and five corporate audit "clients." There were two independent variables. The first was IRS access, which was operationalized as the effect of client-auditor communication on the likelihood that a contingent liability would become an actual liability. Under conditions of IRS access, client disclosure increased this likelihood. The second independent variable was the level of diagnosticity of an audit procedure that served as a substitute for client disclosure. The major dependent measures were client disclosures of specific contingent tax liabilities and the accuracy of the liability estimates made by clients. The results from the laboratory markets suggest several inferences regarding the effects of IRS access to auditors' workpapers. First, IRS access may reduce client disclosures regarding specific arguable tax return positions. Second, a decrease in client disclosure may not necessarily lead to a decrease in financial statement accuracy. Instead, the client's estimate of the tax liability may serve as a reliable substitute for disclosures regarding the specific arguable tax return positions underlying that estimate. Third, IRS access may reduce the number of arguable tax return positions that clients adopt. Taking fewer arguable positions reduces the need for client disclosure and may be an adaptive strategy for minimizing overall tax and audit costs. Fourth, for each of the three variables discussed above (i.e., disclosure, accuracy, and the adoption of contingent liabilities), the effect of IRS access may be contingent on the diagnosticity of any audit procedures that can serve as substitutes for client disclosure. For example, the clients in our laboratory markets were less inclined to withhold information regarding specific contingent liabilities in an environment where auditors could more easily detect this behavior. This result suggests that any inhibiting effect of IRS access on client disclosure may be smaller in situations where auditors have alternative means for assessing the accuracy of the tax provision. Thus, an important issue for future research is assessing the effectiveness of substitutes for client disclosure in real world audit settings.]

[Focusing on funds flow from operations, a way for analysts to use financial statement information to obtain additional insights when assessing a firm's cash generating ability is proposed. The method provides a clearer focus on a firm's cash generating ability from operations. Results from applying the proposed method are compared with information from traditional funds flow statements (APBO No. 19 and SFAS No. 95) for 20 firms, highlighting the incremental insights available.]

[Prior research has developed some econometric properties of accounting valuation rules as linear aggregations of prices and quantities. This study evaluates these proposed properties using actual price data and published price indexes for industrial machinery and equipment for the time period of 1973-1980. Current order prices for 4,875 new industrial machinery and equipment assets were obtained from commercially published pricing guides. The order prices were then used to construct a set of composite price indexes. The Bureau of Labor Statistics (BLS) Producer Price Indexes were also obtained. Various sized asset portfolios were simulated, and the changes in their values were estimated using both the constructed and the BLS price indexes. The changes in estimated and actual values of the simulated portfolios were compared to generate both Bias and mean-squared-error (MSE) measures resulting from the use of price indexes under various experimental conditions. These error measures were then used to evaluate the econometric properties proposed by earlier studies. In addition, total valuation errors were decomposed into movement and measurement components. Movement error is the valuation error attributable to deviations of the relative weights of assets used in constructing price indexes from those of the firm's asset portfolio. Measurement error is the valuation error arising from pricing errors, substitution bias, and inadequate adjustments for technological or quality changes in constructing price indexes. The main results indicate that (1) movement error Bias is zero, but measurement error Bias is nonzero; (2) both MSE movement error and MSE measurement error decline with the use of increasingly fine index systems and with the holding of more diversified asset portfolios, but increase as the asset holding period lengthens; and (3) measurement error tends to be the major source of total error. These findings are based on an assumption that the order prices taken from the commercial pricing guides are void of significant measurement error. Based on these results, it appears that additional effort should be devoted to enhancing price index construction techniques so that measurement error is decreased. Because portfolio diversification appears to reduce all components of error, asset valuations based on a price-index methodology should, perhaps, be restricted to cases involving larger groups of assets rather than very specialized strata of assets. Also, it may be appropriate to restrict the use of price indexes to assets of certain ages, as the study findings indicate that longer asset holding periods are associated with larger errors.]

[As behavioral accounting research has progressed, research designs have become more complex. New topic areas are initially investigated using single-factor designs, which may result in significant effects and a substantial amount of explained variation. In subsequent investigations, explained variation is increased by employing factorial designs and/or multiple-level explanatory variables. Traditionally, ANOVA is the statistical analysis approach employed to test research hypotheses. A limitation of ANOVA is that it only detects significant differences among cell means, but does not indicate the functional form of the relationship among cell means. We propose that researchers employ contrast coding-a refinement of ANOVA-to test research hypotheses. Contrast coding requires researchers to specify a priori the functional form of the relationship among cell means. This article demonstrates that contrast coding provides greater statistical power than the conventional ANOVA without increasing Type I error rates. Examples from recent accounting literature illustrate when the use of contrast coding is most advantageous. The examples include a factorial design and a single-factor, multiple-level experiment. Formulas for calculating the net benefit of employing contrast coding and the significance of the net benefit are presented. The examples and analysis support the use of contrast coding with certain research designs. The primary benefit of the a priori specification required by contrast coding is greater statistical power.]

[This article provides confirmatory evidence of the value-relevance of book values of oil and gas properties. Harris and Ohlson (1987) find that the book values correlate significantly with the inferred market values of oil and gas properties. Reserve recognition accounting requires the simultaneous publication of alternative measures that are often assumed to be more relevant values of the oil and gas properties. The question that logically follows is whether the significance of the book values results from their value-relevance, or whether investors are "functionally fixated" on these accounting values. To address this question, we evaluate zero-investment trading rules based on portfolios constructed from values of the imputed market value (per equivalent barrel of proved reserves). If the security market is informationally efficient, this trading rule should not yield systematic positive returns and the Harris and Ohlson (1987) results then clearly suggest that the book values are value-relevant. We find that the trading rule based on cross-sectional variation in the inferred market values yields significant positive returns that cannot be explained by portfolio risks. This suggests a market inefficiency that could occur because the market "incorrectly" uses book values (per equivalent barrel) to determine market values. That is, functional fixation on book values may be the cause of the successful initial trading strategy. To reject a hypothesis of functional fixation and, thus, the value-irrelevance of book value, it is necessary to try and exploit the book-value-induced cross-sectional variation in the inferred market values. To do this we construct an additional trading rule that controls for the book-value component of the inferred market value. This second trading rule provides even larger returns than the first, and so argues against a simple form of functional fixation. To finally conclude against functional fixation on book values, we consider trading rules that control for other information, in particular the present value of future cash flows. Although these trading rules also yield significant returns, they do not improve on the results from the trading rule that controls for book values. In combination, the results suggest that although a pricing anomaly exists for our sample, the anomaly cannot be ascribed to functional fixation on book values. If anything, investors appear to be paying too little attention to the book values.]