Knowledge that Transforms

[The evaluation of the quality of governmental auditors' work is of keen interest among governmental audit policy-makers. However, as there is little published evidence on which to base such evaluations at this time, this paper discusses the results of an exploratory study on the subject. The study assumes that the extent to which an auditor actually performs the audit procedures prescribed by a given audit program is an important indicator of the quality of the auditor's work. Accordingly, responses were sought from governmental auditors at all levels of government as to their failure to perform prescribed procedures, even though they affirmed performance through sign-offs on their working papers. To offer anonymity to the respondents and to encourage truthful responses, the survey was based on the randomized response technique. The findings indicate that a number of false sign-offs have occurred among governmental auditors as a group. Within the governmental group, the study found that false sign-off rates were slightly higher among auditors at the state level than those at the federal level. Also, rates were slightly higher among auditors not working under a civil service system than those who were, and higher among those who were not certified compared to those who were. It also found that independence of the audit function was not helpful in explaining positive false sign-off rates. However, the significance of these differences as a way of describing the false sign-off rates of governmental auditors was not strong.]

[Current financial reporting practices have traditionally emphasized measures of accrual earnings. On the other hand, the link between future cash flows and firm value is well accepted by financial economists, and recently there has been increased interest in measures of cash flow. This paper provides evidence on the role of accrual (i.e., earnings and working capital from operations [WCFO]) and cash flow measures in an explanatory model of security prices. This issue is first examined by testing for an association between unexpected security returns and unexpected cash flows, after controlling for the relation between unexpected returns and unexpected earnings. We also examine the obverse issue by testing for an association between unexpected security returns and unexpected earnings, after controlling for the relation between unexpected returns and unexpected cash flows. We test these relations in two contexts: in results pooled over the entire ten-year time period studied and in year-by-year cross-sectional regressions. Results for our complete sample are generally consistent with: (1) cash flow data having incremental information content relative to that contained in earnings; (2) cash flow data having incremental information content in addition to that contained in earnings and WCFO; and (3) accrual data (i.e., earnings and WCFO) jointly and separately having incremental information content in addition to that contained in cash flow data. However, the results do not support the hypothesis that WCFO has incremental information content relative to that contained in earnings.]

[This paper describes the construction of an expert system for making planning-stage materiality judgments. The purpose of the study was to investigate how various types of quantitative and qualitative information influence those judgments. A rule-based expert system was built as a vehicle for this descriptive research because its use of If-Then rules to represent domain knowledge makes both the role played by various pieces of information and the reason for using that information explicit. The system's judgment model breaks down the materiality judgment process into two separate decisions: (1) a choice of the appropriate base for calculating materiality and (2) the selection of a percentage rate to multiply by that base. Examination of the rules used by the system indicates that information about (a) the nature of the client, (b) future plans of the client, and (c) perceptions of the needs of financial statement users influences the choice of a materiality base. Information about the intended use of the financial statements and the nature of the audit engagement affects the selection of the percentage rate.]

[Several new methods of evaluating dollar-unit samples have been proposed recently for use in auditing. This paper presents results of a simulation study that compared four of these new methods. Additional simulations on alternative forms of two of these are also presented. Evidence on the reliability and relative size of the upper error bounds for each method is provided for 2,160 different combinations of sample sizes, confidence levels, and types of accounting populations. The results provide a comprehensive analysis of the capabilities of these methods. All four methods have strengths and weaknesses. The Multinomial Dirichlet bound is quite reliable but very conservative and (as formulated) not able to utilize understatement errors. The two versions of the Cox and Snell bound that were tested (with different priors) varied considerably in their reliability over a range of confidence levels. While not without an occasional reliability problem, test results for the Moment Method bound and one of the two Bayesian-Normal bounds were largely favorable.]

[When making audit judgments and decisions, an auditor often relies on knowledge or information about how task variables covary. Typically, an auditor generates this information without the aid of a formal covariation model. Thus, the quality of audit judgments and decisions which rely on covariation information may depend on an auditor's ability to judge covariation in a manner that is paramorphic to a formal model. This paper reports two experiments examining the rules by which auditors integrate joint frequency data when making covariation judgments and whether their judgments are affected by context, prior expectations, and amount of auditing experience. A main result was that the subjects generally used data-integration rules that were sensitive to the objective covariation level, but often overstated or understated this level. The effects of context, prior expectations, and amount of auditing experience were generally small.]

[Many researchers describe themselves as Bayesians in that they revise their prior beliefs based on observed empirical evidence. However, most studies are designed and reported as classical hypothesis tests, and research design issues are typically considered as determinants of abstract properties of statistical tests. Thus, although the primary function of empirical research is to influence beliefs, research design issues are seldom considered in their fundamental role as determinants of beliefs. In this paper, a Bayesian perspective is used to analyze the role of basic properties of hypothesis tests in the revision of beliefs. Two main points are emphasized. First, hypothesis tests with low power are not only undesirable ex ante (because of the low probability of observing significant results) but also ex post (because little probability revision should be induced even when significant results are observed). Second, irrespective of the usual issues of statistical and methodological validity, the effective level of tests in published research is likely to exceed the stated level, thus reducing the amount of probability revision justified by reported results. In combination, these conclusions are especially troublesome. If tests reported in the accounting literature are characterized by both low power and high effective levels, the results of published tests properly have little or no impact on the beliefs of a Bayesian. The Bayesian framework is useful in understanding and analyzing the tradeoffs which are an inherent part of empirical research. The analysis here identifies a Bayesian motivation for the common recommendations that researchers should attempt to maximize power in the design and execution of empirical tests and attempt to maintain the effective level of tests at their stated levels. Further, the analysis demonstrates the importance of explicit descriptions of research choices to allow (Bayesian) readers to properly revise their beliefs in response to reported empirical evidence. Finally, the model illustrates the role of prior beliefs and the characteristics of empirical tests in research and publication decisions.]

[The neutrality and equity aspects of the Accelerated Cost Recovery System (ACRS), which became part of the U.S. tax law in 1981, are examined using a Monte Carlo simulation. ACRS depreciation is found to be equivalent to general price-level adjusted (GPL) depreciation only at inflation rates of between nine and 13 percent. To the extent that corporations alter their production, investment, and financing activities as a result of inflationary misstatement, the post-1980 law is nonneutral during times of inflation. Further, ACRS will result in a substantial, disproportionate relative capital shift among industries during inflationary periods, which indicates the horizontal inequity of the post-1980 law. This capital shift will be largest for capital-intensive industries having long-lived assets, such as transportation, utilities, and real estate. Both nonneutrality and horizontal inequity lead to decreased economic efficiency and a deadweight loss to the economy.]

[This note examines the extent to which firms affected by a change in the tax law respond by making changes in the accounting methods used for financial reporting. The specific tax issue considered is the Thor Power Tool case that limited the use of formula write-downs for inventories. Since LIFO could be approximated by formula write-downs, we hypothesize that affected firms will tend to switch to LIFO during 1979 (and only during 1979) for tax reporting purposes and (because of the LIFO conformity rule) for financial reporting purposes as well. The empirical analyses of inventory method changes are consistent with this hypothesis.]

[This paper reassesses the information content of annual earnings announcements using errors in analyst forecasts published within one week of those announcements as the proxy for unexpected earnings. In addition to the use of analyst forecasts near to the announcement date, features which distinguish this study from earlier work include: a more precise dating of earnings announcements; a comparison of analyst forecast errors and changes in fourth-quarter earnings as proxies for unexpected earnings; tests of unusual variability in excess returns at the time of earnings announcements with the influence of forecast errors removed; a separation of early and late disclosers within an industry; and an examination of the properties of forecast range as an ex ante measure of earnings predictability. We conclude that: provided that analyst forecast errors measure unexpected earnings, annual earnings announcements have information content even when compared to market expectations very near to those announcements; analyst forecast errors do not dominate fourth-quarter changes as a proxy for unexpected earnings; other information released concurrently with earnings announcements appears to have significant pricing implications; there is greater information content in earnings announcements of early disclosers than of late disclosers; and forecast ranges may provide a reasonable measure of the error in analyst forecasts, and hence of earnings predictability.]

[In this study, sections of working papers from audits performed by one office of a public accounting firm were obtained and investigated. The working papers contained the information documented from the preliminary evaluation of internal control over the accounts receivable/sales area. Data from the working papers were provided as input, and discriminant analysis was used to construct a descriptive model of the auditor preliminary evaluation judgments. The model correctly predicted about 80 percent of the individual auditor judgments, which is significantly more accurate than a chance model, and the importance of the presence or absence of particular control activities on the auditors' evaluations was investigated from the model.]